The return of event risk

With equities improving and firms finding easy access to capital markets funding, M&A activity has been picking up in both the US and Europe. But does this increase in firms’ discretionary spending spell trouble for bondholders? Philip Moore reports

Key points • Conditions are ripe for an increase in M&A volumes. • So far, most of the deals have been defensive rather than aggressive. • Firms are now more reluctant to finance acquisitions with debt, as recent low issuance indicates.

The research note that dropped on credit investors’ desks on the day they returned from their Easter holidays was hardly earth-shattering, but it appeared to be symptomatic of an increasingly conspicuous trend. This particular bulletin, from Dresdner Kleinwort Wasserstein, advised that Daimler-Chrysler was rumoured to be planning to inject as much as €2bn into Mitsubishi Motors as part of a bailout plan. “If such a cash payment is confirmed it could trigger rating pressure,” said the research note. It added that speculation was also mounting that Daimler-Chrysler would raise its present 37% stake in Mitsubishi Motors to a majority holding as early as 2006.

There is no reason why, in isolation, a news flash of this kind should ring alarm bells for credit investors. But warnings about companies’ cash spending plans are emerging with growing frequency. In March, for example, DrKW published a report entitled The Return of M&A?. It began: “JPMorgan buying Bank One, Sanofi’s hostile bid for Aventis, Comcast’s hostile bid for Disney, and Cingular’s successful bid for AT&T Wireless are four high-profile, US$40bn-plus M&A transactions which have heightened bondholder concerns of rising event risk in 2004.”

DrKW added that “a continuation of equity gains is likely to result in more M&A activity this year, especially given the favourable access to funding in both debt and equity markets at present.” Others agree that conditions are ripe for an rise in M&A activity in 2004 on both sides of the Atlantic, with the palpable improvement in global credit quality one factor that could embolden predators.

Ed Marrinan, head of credit strategy at JPMorgan in New York, falls into the camp of analysts believing that conditions today are almost the perfect recipe for an upturn in M&A volumes. “In many industries excess capacity, or what I would call excess competition, is diminishing the returns that companies can deliver to their shareholders,” he says. “Eliminating that excess competition through M&A is clearly a viable proposition for many companies, especially at a time when there is an abundant availability of financing globally.”

Telecoms

Clearly, some industries are already presenting themselves as more likely candidates for M&A-induced event risk than others. Take the telecoms sector, which became the enfant terrible of credit markets in the late 1990s. European telecoms companies, in particular, have paid down debt, patched up their balance sheets and are now luxuriating in rising levels of excess liquidity, the likes of which they have not seen for the best part of a decade (see Credit, March 2004, pages 34–37).

Peter Plaut, credit strategist at Bank of America in London, calculated in a recent report that this generation of free cashflow will amount to something in the region of €100 billion between 2004 and 2006. True, said Plaut, most of this cash will be used to repay maturing debt, but with the balance likely to be channelled towards dividend hikes, share buybacks and rising M&A activity, event-sensitive investors may have good cause to become a little jumpy. As Plaut’s report advised: “We are already seeing signs that management’s past preoccupation with free cashflow generation and balance sheet repair is shifting to an increasing focus on strategic moves. Management is now seeking to maximise shareholder value, which may represent increased risk for bondholders, in our view.”

It is not just telecoms and autos that have shown signs of being prone to event risk in the last few months. Take the recent example of UK retailer Sainsbury’s, which has announced plans to offload its US retail arm, Shaw’s Supermarkets, and return cash to its shareholders with some of the proceeds. That, rather than the general trading environment, seemed to be the principal reason offered by Standard & Poor’s for the downgrade in Sainsbury’s rating from A- to BBB in March.

“The downgrade reflects the weakening of Sainsbury’s financial profile following the group’s decision to return to shareholders approximately 55% of its net proceeds from the sale of Shaw’s,” S&P said. “In addition, during financial year 2005, the group is likely to apply a significant proportion of the remaining proceeds from the divestiture on the possible acquisition of some Safeway stores.” In other words, Sainsbury’s has been happy enough to pursue a strategy dedicated to shareholder value which is detrimental to its ratings profile.

Does any of this mean that credit investors should become more alert to the dangers of a broader reawakening of event risk? It certainly does, thinks Neil McLeish, credit strategist at Morgan Stanley in London, who believes that the three warning signs of rising M&A activity, share buybacks and capital expenditure (capex) should all warrant investors’ attention.

“Rather than talk about event risk, we look more broadly at discretionary spending by companies, which is clearly rising,” says McLeish. Nor, he says, is it just the telecom sector that is sending out the warning signals. “Things aren’t comparable to the late 1990s, which is why at this stage I would be waving an amber flag rather than a red one. But it would be complacent to ignore the warning signals.” Especially against the backdrop of a market starved of new issuance and in which investors may be prepared to lower their guard in pursuit of increasingly elusive opportunities.

Others appear to be more relaxed. Investors themselves hardly seem to be losing sleep over the potential for event risk, or to be haunted by memories of the notorious events of the late 1990s, such as the Mannesmann fiasco (see box overleaf). At ABN Amro Asset Management in Amsterdam, for example, Marc Vernooij says that for the time being he is unconcerned about event risk. “As long as M&A continues to be undertaken in a very prudent way without huge debt being taken on board to finance it, that’s fine,” he says. “In that respect I don’t yet see any similarities with the late 1990s when companies took on a lot of debt to finance all sorts of M&A deals.”

Some market indicators seem to agree. “A telltale sign of how low a priority the market is now placing on event risk is the compression of credit spreads,” says David Goldman, global head of debt research at Bank of America in New York. Historically, he says that a symptom of heightened concern about event risk has been a large number of “outliers” in terms of spread – with investors demanding hefty premiums for those companies perceived to be most vulnerable to event risk. Compression of spreads within a fairly uniform range, by contrast, tends to indicate that the market is relatively relaxed about event risk.

On the defensive

There are at least two reasons why investors need not fear the re-emergence of the sort of event risk that left many credit investors badly shaken in the late 1990s. The first is driven by changes in the business cycle, while the second has more to do with the culture and structure of the credit market today.

In terms of the business and investment cycle, many credit strategists argue that the volume of M&A activity in general, and of debt-financed M&A in particular, is no cause for concern yet. They also say that investors looking for indications about the potential for event risk should keep an eye on the type of M&A transactions that are being executed, and the motives behind them, rather than on the volumes in isolation.

“I’d argue that the volumes we are seeing are not huge,” says Suki Mann, credit strategist at SG CIB in London. “And the sort of deals in the market recently have not been transformational transactions from companies necessarily wanting to become global market leaders, as they were in the 1980s and 1990s. Instead, they’ve been defensive-oriented deals. Sanofi-Aventis is all about trying to solidify a position in the top three, and JPMorgan-Bank One was about fortifying a position in the US rather than pursuing a global growth strategy.”

Far from fretting about the rise of M&A, Mann even suggests that a little bit of event risk would be a price worth paying if a more energetic round of M&A activity could breathe life into credit’s comatose new issue market. But at the moment, he sees no sign of an explosion in M&A volumes. “Following the excesses of the 1990s I think most companies are still focusing on deleveraging and getting their balance sheets in order,” he says. “If you look at the business investment outlook, it’s still quite poor, which suggests that companies are still reluctant to embark on major capex projects which won’t necessarily generate worthwhile returns.”

This is a view shared by a number of other credit strategists. At BNP Paribas in London, senior credit strategist Paola Lamedica says there is no reason to believe that M&A activity in Europe is going to spark a renewed round of ratings downgrades. She argues that there is much less scope for companies to make large, transformational acquisitions than there was in previous cycles, especially in heavy industrial sectors such as cement, paper or mining which are characterised by virtual oligopolies. As a result, she believes that the majority of acquisitions will involve companies buying smaller strategic assets or brands, often in high-growth emerging market regions. Deals of that kind are unlikely to exert much pressure on companies’ balance sheets. “So my feeling is, don’t panic,” says Lamedica.

A second factor that may help to keep a lid on event risk, especially in the US, is that following the excesses of the late 1990s large cross sections of the corporate sector are virtually on probation, their every move being scrutinised by investors, not to mention regulators. “At this point in the cycle, corporate management is still trying to signal its caution and risk aversion to the market, which means that the likelihood of another extreme event of the Enron or WorldCom variety is that much lower,” says Bank of America’s Goldman.

Even allowing for the misdeeds at Enron, WorldCom and elsewhere, it is clear that culturally, the corporate universe is still a million miles away from the excesses that characterised the late 1980s. But how, in today’s market environment, do you tell if the mercury is once again rising on the hubris barometer, encouraging corporate hotheads to plunge headlong back into the world of excessive leverage and risk-taking?

“I think the main symptom you have to look out for is the willingness of the market to buy equity at stupid prices,” says Goldman. “And although stock markets have recovered, equity indices are still well below the peaks they reached in the last cycle.”

That, says Goldman, is important because it restricts the capacity of companies to extend their borrowings in the belief that they can subsequently be bailed out by the equity market – just as many telecom companies did in the late 1990s. In Europe, many of these issuers assumed that they could refinance themselves by spinning off assets to equity investors at preposterous multiples. And in the US, high-yield investors were reassured by equally absurd equity valuations. “We saw a vast number of telecom deals in 1999 and 2000 that were unrated,” says Goldman. “Issuers did not even bother to get to the first base of triple-C because they had no cash. But high-yield investors assumed that there must have been substance behind their business plans because their equity ratings were so high.”

If credit investors can draw comfort from sensible equity valuations, they can probably also derive some from market practice within the credit universe today, in comparison with the late 1990s. For now, that market practice appears to be leaning in favour of funding M&A with equity, rather than via added leverage. As Gary Jenkins, former head of credit research at Barclays Capital, advised in February: “Event risk is, of course, always with us, and it could be argued that we are at the stage of the cycle where stock-for-stock mergers are likely to be more the norm than large cash deals... Event risk of this nature is not as confidence-sapping as was the case during the last boom.”

Others point out that there does appear to be a genuine change of attitudes towards leverage within the corporate universe, with one analyst pointing to Comcast’s $54.1 billion bid for Walt Disney as an example of the process. “Comcast indicated that it would only offer equity for Disney,” he says. “It said that it wouldn’t leverage up its balance sheet to buy Disney even though it is a once-in-a-lifetime opportunity for Comcast, and it has stayed true to that statement – so much so that it now looks as though it may be forced to withdraw its offer.”

Comcast is not alone in apparently embracing a wariness of leverage. “One of the most interesting pieces of news we’ve heard recently was that all of the auto companies have indicated that they plan to reduce their debt issuance in order to maintain their credit ratings,” says Goldman at Bank of America. “As recently as 2000 and 2001 the auto companies were serial issuers, but one of the reasons that debt issuance has disappointed even the most conservative estimates this year is that corporate managers are genuinely anxious to maintain their good standing with bond investors.”

In a number of other sectors, however, the jury seems to be out on whether companies are being more bondholder-friendly by design or by coincidence. Some argue that vulnerability to event risk is too company-specific for analysts to reach sweeping, sector-wide conclusions. In the US, take the example of soft drink and snack maker PepsiCo, which at the start of April told its shareholders that it would be hiking its dividend by 44% and buying back up to $7 billion of its stock over the next three years – a double move clearly aimed at supporting the interests of its equity investors and potentially encouraging copycat moves from competitors within the same sector.

“Is that event risk?” asks Marrinan at JPMorgan. “Is that the sort of thing that bondholders should be worried about? Of course it is. But in terms of its balance sheet and ratings, PepsiCo is strong enough to pursue this kind of shareholder-friendly strategy without inflicting any great damage on its credit profile or on its bond spreads.” Nor is PepsiCo alone, believes Marrinan. There have been a number of other companies that have embarked on similar shareholder-friendly activity which has only had a limited impact on their credit spreads and ratings.

One prominent example, says Marrinan, is BellSouth and SBC Communications, members of the Cingular Wireless consortium that pipped Vodafone in the battle for control of AT&T Wireless with their $41 billion cash bid. “Yes, there were negative ratings consequences there,” says Marrinan. “But the consequences for bondholders are looking less painful than they may have been.” BellSouth and SBC have both articulated that the public borrowings arising from the AT&T Wireless will be considerably lower than many people had been speculating prior to the deal. According to Marrinan, that is partly because they are using asset sales to cushion some of the financing requirements, but also because both companies’ cashflows are strong and their debt profiles are reasonable.

If there is a resurgence of M&A activity in Europe, companies there may also have pleasant surprises in store for investors. At Citigroup in London, credit strategist Roberto Fumagalli says that his group’s estimates of net corporate earnings and debt growth for 2004 reveal that there will probably be enough cashflow to subsidise shareholder-friendly behaviour without upsetting bondholders. “The bottom line is that companies can continue to deleverage, increase dividends, buy back shares and do some small M&A activity without turning the process of deleveraging upside down,” he says.

That sounds almost as though investment management companies are enjoying the best of both worlds, with sweeteners being handed to equity investors without upsetting the bondholders who may well occupy the office next door. But credit strategists warn against believing that this is anything more than a happy and temporary coincidence. “Companies are owned by shareholders, not by bondholders,” says Fumagalli. “And when earnings growth slows down, firms need to find ways of delivering value to their shareholders. Perhaps this cycle will be less harsh for bondholders than the last one was, but there is still a swing of the pendulum away from bondholder and towards shareholder interests.”

But nowadays, in Europe at least, credit investors are much better equipped to respond proactively – and collectively – to the threat of event risk than they were five years ago. Bondholders have put the corporate world on notice that they will no longer stand for the sort of behaviour which, in the late 1990s, all too often abused their support. Flimsy documentation, for example, tended to leave the less experienced credit investors vulnerable to event risk, with the Stagecoach episode providing a memorable example (see box below).

At Merrill Lynch in London, credit strategist Crispin Southgate sees event risk “increasing marginally but not to a worrying degree at this stage”. One of the reasons for that relatively optimistic stance, he says, is that bond investors are considerably less malleable than they were at the end of the 1990s. “Two or three years ago companies were confident about being able to do whatever they wanted,” he says. “These days they are having to think twice about doing things that might not prove acceptable to the investor community.”

Mannesmann “Mannesmann’s future potential investments will be funded prudently and will not preclude it from gradually strengthening its debt protection ratios,” advised Moody’s in June 1999, saying that the German company’s A2 rating was stable and likely to remain so. That would have been a relief to credit investors who had grown twitchy about the €8 billion or so of debt that the company had taken on in the previous eight months to finance an acquisition spree. Their relief was short-lived. On October 21, 1999, Mannesmann dropped its bombshell, announcing that it had just secured a €12 billion one-year syndicated loan facility to finance the cash element of its bid for Orange, a substantial slug of which would have to be refinanced through the bond market within 364 days. As a result, said Mannesmann, its rating was likely to deteriorate to triple-B plus or even triple-B. The bond market’s reaction was brutal, and within a single day the spread on Mannesmann’s €3 billion 10-year benchmark bond widened by more than 20bp to 121bp over the German government curve. Other telecom bonds from issuers such as BT and Vodafone widened in sympathy. “It shows bondholders are not important,” one exasperated investor was quoted as telling the FT.

RJR Nabisco The battle for control of RJR Nabisco in the US in 1988 is widely regarded as the mother of all event risk stories as far as bondholders are concerned. The episode, immortalised in the Burrough and Helyar novel Barbarians at the Gate and the 1993 film of the same name, was notable in two respects. First, the numbers involved were quite simply mind-boggling, with the stakes rapidly rising from $17 billion to $25 billion – the eventual price tag when RJR was acquired by KKR in April 1989. Second, when the opening salvoes were fired in the battle, with RJR Nabisco’s announcement of its LBO plan, the spread on its most liquid triple-A bonds widened virtually overnight from 100bp over Treasuries to a 350bp differential. Spread widening of that kind was unprecedented in the investment-grade segment of the US corporate bond market, and contagion quickly spread to the outstanding bonds of companies perceived by the market as being comparable to RJR, such as Anheuser-Busch and Sara Lee. Event risk had stamped itself indelibly on the US credit market.

Stagecoach Investors in the sterling corporate bond market are a demanding bunch. That is why when Stagecoach launched a sterling transaction in the late 1990s, the documentation that went with it was seen as a matter of routine. This stated that an event of default would have occurred “if the issuer or any Material Subsidiary shall cease or threaten to cease to carry on the whole of its business or a substantial part thereof”, and if the trustees determined that the event was “materially prejudicial” to bondholders. There was no such clause in the documentation for a €400 million five-year bond issued by the same borrower in November 1999. So when, some months later, Stagecoach sold a subsidiary and protected itself against possible claims from sterling-based investors by calling its sterling bond, it made no such concessions to holders of the euro-denominated issue. As a result, while the spread on the sterling bond tightened dramatically, the euro bond immediately widened to such a degree that it became one of the worst performers of the year in euros. For euro-based bondholders new to the credit game, it was an expensive lesson in the importance of studying the small print and, if necessary, calling more vocally for watertight protection.