Published on October 5, 2018

The recent Blackstone->Thomson Reuters acquisition reminded us once again why we need to be extra vigilant when evaluating sponsor backed deals.

Although leveraged buyouts (LBOs) are generally among the largest and most high profile deals in the high yield market, we find they frequently contain unfavorable surprises. The recent Blackstone acquisition of Refinitiv, the Financial and Risk division of Thomson Reuters, was an excellent example of why we tend to stay away from these bonds.

Investor Protections Are Limited

The deal was structured like most of the sponsor-backed issues we analyze – the headline elements (e.g., coupon, maturity, call protection) were more-or-less in line with the broader market, but a closer look under the hood revealed significant structural deficiencies. In this case, the coupons were a little above market given the issuer’s low credit rating (Caa2, Moody’s and B-, Standard & Poor’s), but the covenants were extremely weak. Most importantly, Blackstone asked investors to assume that the $500 million in cost savings they are expecting to achieve over the next 5 years will be fully realized at the closing of the deal — a giant leap of faith that substantially reduced borrower’s leverage ratio. In addition, there were unusually loose terms governing restricted payments, including allowing the issuer to pay dividends to its owners even if the firm comes under severe financial distress, directly penalizing bondholders who are senior in the capital structure to the equity holders.

These types of covenants are consistent with the general pattern we’ve observed in recent LBOs. The financial sponsors – usually private equity firms that own the borrowing entity – intentionally issue bonds with weak bondholder protections that allow the sponsors to maintain maximum control and flexibility over the decisions they make regarding their businesses.

Bondholders, on the other hand, would like the issuers to adhere to rules that limit their ability to spend money carelessly or raise large amounts of new debt, both of which could impair their ability to pay bondholders back in the future.

In many segments of the high yield market, issuers and bondholders negotiate covenants such that both sides receive at least some of what they require. But in most of the sponsored-back deals we’ve looked at, there is minimal give-and-take and the terms heavily favor the sponsor.

Index-Driven Investors Support the Market

So how is it possible that these deals continue to come to market successfully and raise such large sums of money? The Thomson Reuters deal raised $13.5 billion, making it the 9th largest leveraged buyout on record (in both the United States and Europe). Who are the investors that are willing to turn a blind eye to the obvious risks they present?

In our view, the key to the commercial viability of these deals is the fact that they become significant components of the high yield (HY) indices, which HY exchange traded funds (ETFs) and many HY managers use as their benchmarks. Passive vehicles are therefore required to purchase them, as are many index-centric actively managed funds.

These benchmark oriented investors manage their portfolios on a relative return basis, which means they also try to replicate an index to limit tracking error (i.e., the difference between the return of their portfolio vs. that of their benchmark). So, like passive funds, they are effectively compelled to buy these deals even if they don’t necessarily like the structure or pricing. They may adjust the weights in their portfolio vs. the index, depending on how confident they are in a particular issue, but they generally hold them regardless.

“Common Sense” Investing Is Key

In our opinion, relative-return investing is too limiting, so we have always used an absolute return approach. We are benchmark-agnostic, which allows us the freedom to invest in only the securities we find attractive and to avoid areas we feel are sub-optimal merely to keep up with an index.

We call it “common sense investing,” and we find it is the most effective way to achieve our dual objectives of preserving capital and attaining long-term total returns. To that end, we are particularly selective about sponsor-backed bonds issued to finance large leveraged buyouts.

 

Craig L. Manchuck

Vice President & Portfolio Manager

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Coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semiannually.

Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist.

Call protection is a protective provision of a callable security prohibiting the issuer from calling back the security for a specified period of time.

Leverage ratio is a financial measurement that looks at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations.

Investment grade and non-investment grade (high yield) categories are determined by credit ratings from Standard and Poor’s and Moody’s, which are private independent rating services that assign grades to bonds to represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Standard and Poor’s ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. Moody’s ratings are expressed as letters and numbers ranging from ‘Aaa’, which is the highest grade, to ‘C’, which is the lowest grade. A Standard and Poor’s rating of BBB- or higher is considered investment grade. A Moody’s rating of Baa3 or higher is considered investment grade. A Standard and Poor’s rating below BBB- is considered non-investment grade. A Moody’s rating below Baa3 is considered non-investment grade. If an issue is rated by both agencies, the lower rating is used to determine the sector. Fund breakdown by credit ratings are based on Standard and Poor’s ratings. Not Rated Securities consists of securities not rated by either agency, including common stocks, if any.

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