There are countless nuance and peculiarities stitched into the fabric of every financial market across the world; from equities, commodities, foreign exchange and credit, there are an abundant number of imperfections. Today we will explore a few crinkles in the credit markets, a topic of particular interest given the credit cycle has likely crested with central banks now raising interest rates and tightening liquidity (certainly a contributor to the significant volatility we have seen in equity markets recently).
One of our favorite asymmetries on the short side which we have discussed numerous times on this blog is debt and leverage. There are few more powerful catalysts for value destruction than an over-leveraged business that is facing structural decline. Similarly, the reverse is also true, in that there are few more powerful catalysts for value creation than a business that is about to embark on an earnings driven deleveraging, which of course is one of our biggest fears when shorting leveraged companies.
Unfortunately improving business fundamentals are not the only thing we need to be cautious of when shorting a highly indebted business, specifically we need to be very careful of the credit side of the equation. In this yield constrained world, creditors have become increasingly willing to accept less protections (covenants, etc.) on loans and bonds that they provide to riskier companies. One of the most interesting and potentially dangerous developments to emerge (on the short side) is the loosening of language in credit documentation involving “unrestricted subsidiaries”. Generally speaking when a company borrows money (debt) it is assumed that if it does not repay it, the lender can assume control of the business and all of its assets. In reality this is often not the case, particularity for high yield companies (rated BB+ and below), which are usually highly indebted and can make for attractive shorts.
An “unrestricted subsidiary” is basically a subsidiary that creditors do not have a claim over (or a much weaker claim) and which the company doesn’t need to comply with lender protections, such as covenants, guarantees, etc. Furthermore companies with loose lender provisions can actually transfer a material amount of value away from creditors and distribute it to shareholders (e.g. dividend, assets, etc.). An example of a company (and there are several) using this type of subsidiary and loose credit documentation is PetSmart (pet supplies business).
Earlier this year PetSmart transferred a stake in its recently acquired $3.4bn online pet business Chewy.com to an “unrestricted subsidiary” that would be protected from its lenders in a bankruptcy (permitted under the credit documentation). Specifically, PetSmart moved a 16.5% stake (worth $550mm) in Chewy.com to an “unrestricted subsidiary” and another 20% (worth $660mm) went as a dividend to shareholders, both of which avoided creditor claims sending PetSmart bonds sharply lower (the benefit accrued to equity holders). PetSmart is a private company so we can’t see the change in equity value in real time, however the value leakage for bondholders is abundantly visible in the chart below.
Rating agency Moody’s has stated that lender protections have materially eroded over the last several years and it is much easier for businesses to both shift assets, issue more debt and pay dividends at the cost of creditors than ever before. As we move deeper through the credit cycle and accelerate towards a distant trough, we will eventually see the next wave of bankruptcies. However lenders are in much worse shape in terms of recovering their capital. Historically speaking the typical recovery rate on a defaulted leveraged loan is 77 cents on the dollar, however Moody’s estimates this will likely decline to 61 cents in the next downturn.
We have previously discussed some of the dynamics at play in the high yield market and particularly leveraged loans here. It is for these reasons it is essential to have a solid perspective on what a company may be able to do in the face of an over-leveraged balance sheet, simply having too much debt and a bad business doesn’t necessarily make for a good equity short.
Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.