On the Fritz

Issuers gain in covenant game

In the never-ending struggle over financing terms,issuers have been getting the better of it lately. With high-yield mutual fund inflows setting a record in 2003 and with a sizable chunk of the new issuance merely refinancing existing bonds, demand has outpaced supply. The most obvious impact on pricing has been an unprecedented one-year narrowing in the high-yield index's spread versus Treasuries. Less easy to measure, yet unquestionably substantial, has been the value captured by issuers through the skewing of financing terms in their favor.

For one thing, issuers have chipped away at investors' protection against early redemption. One device has been to increase the percentage of the outstanding amount that can be retired with proceeds of an equity sale, despite the standard five-year prohibition on premature call. The customary 'clawback' percentage has been 35%, but in an offering of December 10, 2003, bedding manufacturer Simmons, to cite one example, successfully pushed it to 40%.

A more dramatic example of an issuer reserving the right to snatch bonds away from investors involved Sweetheart Cup, a maker of disposable catering products. The company's four-year senior secured note, floated on December 16 last year, was immediately callable at a modest two-point premium. Soon after, the company announced a definitive pact to be acquired by rival firm Solo Cup and declared: "In connection with the acquisition, all of Sweetheart's outstanding notes will be repurchased or redeemed.

Restaurant operator El Pollo Loco recently showed particular ingenuity in gaining an edge in the covenant game. On the cover of its preliminary prospectus, El Pollo Loco states that buyers of its new 10-year bonds could compel the company to repurchase the issue at 101% of principal amount in the event of a change of control "as defined in the indenture".

A description of the relevant provision on page 7 omitted the qualifier: "as defined in the indenture". Only investors who persevered to page 111 learned that, contrary to what they might have supposed, a change of control did not simply mean a sale of the company. It turns out that a changeover in ownership does not count as a change of control if the acquirer injects $75 million of cash into the company.

One could argue that an equity infusion of that magnitude would mitigate fears of the acquirer being a quickbuck, asset-stripping type. Therefore, the company might say, it would not be imperative for lenders to get their money back and negotiate terms anew. Still, many battlescarred portfolio managers would prefer not to give issuers a free hand to sell to any acquirer. Some potential asset acquirers are latter-day Houdinis, renowned for their ability to escape from straitjacket-like covenants.

Unfortunately, investors who hew to a strict line on covenants will probably find it hard to stay fully invested. Issuers are currently in a position to dictate terms and are likely to remain so as long as cash continues to pour into the high-yield sector. Treasurers realize that they will not enjoy the advantage forever, so companies with strong motivation to deviate from the norms are likely to represent a sizable portion of the calendar in the near term.

Martin Fridson is a veteran of high-yield analysis and the founder of FridsonVision, an independent provider of high-yield research (www.leverageworld.com).
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