Friday Workout - Transmission Ramp, PIK n Play, Never Grander or Just Wishful Thinking
- Chris Haffenden
Omicron continues to divide opinion and markets. Risk was back on this week, amid talk of third doses effectiveness and milder symptoms. But the UK Government was worried enough to initiate Plan B on Wednesday (after its Wham strategy failed) citing the much greater transmissibility of the new variant. Cynics would say it was a Dead Cat to divert from politics around parties, but time will tell if the recovery in risk assets this week was a dead cat bounce, or the start of another leg of the bull rally.
So, what should we make of the latest data on Omicron?
It is a positive that third doses can be effective against the mutation amid early evidence thus far of less hospitalisations. But only 65% of citizens in the US and Europe are double jabbed, which is much less effective against the new strain. A Japanese study suggests it is 4.2x more transmissible than Delta, applying simple maths the R rate could rise markedly in a short period of time, I’m not sure this is fully understood by markets.
But to date, most governments are unwilling to impose draconian lockdowns, amid concerns of compliance fatigue and effects on economies (it is estimated the UK’s Plan B will cost £18bn). While Christmas might indeed be better than last year, January could be tougher, as transmission ramps.
I wonder if Omicron is a dead cat for risk assets, as it deflects attention from rampant inflation and taper tempers? With a 6.8% US inflation print, Fed meeting next week and with several Central Banks expected to raise rates, we are likely to find out.
PIK n Play
HoldCo PIKs are often described as a top of the market instrument, allowing sponsors to pile on more leverage outside of the 6x norms, and pay themselves dividends. This year, we have seen a sharp rise in the number of deals, most recently Burger King France and Lottomatica.
But they can be very useful in restructurings too.
In many restructuring cases with varying stakeholders with different interests and motivations – par lenders keen to avoid haircuts, distressed funds looking for equity upside, CLOs may be unable to take equity – there is a requirement to maintain more debt in the capital structure than ideal, and to offer equity alternatives.
This is where the HoldCo PIK comes in. It allows more debt to be kept in the capital structure, while keeping cash interest costs low. The PIKs can be deeply subordinated (structurally and contractually) whilst allowing some holders to classify as debt, often the equity is stapled to the PIK. The debt tiering can also provide embarrassment insurance if the business recovers more strongly than expected – the ‘hope’ notes could return to being in the money, rather than providing option value. Conversely, if the business doesn’t recover, the Opco/Holdco structure makes a second restructuring easier by detaching the Holdco PIKs without affecting the remainder of the debt stack and operations.
There are downsides, the roll-up of the debt at double-digit rates can easily outpace the growth in cash flows and recovery in EV. Often the PIK debt is rarely quoted, valued and traded, and with equity stapled in many cases, it can be difficult to extract equity value.
Last Friday, Lowen Play provided a business and investor update outlining the terms of its planned restructuring and its new business plan. The Germany-based operator of gaming arcades and Casinos had been hit by regulatory changes and Covid-restrictions. Earlier this year we flagged that it would be difficult to refinance their November 2022 SSNs, with a 25 October cleansing presentation widely interpreted as calling time on the refi negotiations.
As we outline in our restructuring QuickTake “there is no deleveraging, but the debt will be split into a Opco/Holdco structure, which the company says will ‘materially deleverage the Opco balance sheet’, with Opco net debt projected at 3.5x on projected FY22 adjusted EBITDA (as per presentation, based on pre-IFRS16 numbers).”
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We go on to say: “The Opco/Holdco split makes it easier to restructure further down the line if the business fails to recover as projected under the revised business plan. The €40m SSRCF will be repaid from cash on the balance sheet at completion. Debt maturities are extended until Dec 2025 and Sept 2026, with higher interest payable on the reinstated Opco debt, but overall interest costs will reduce slightly on an annual basis. In return for their consent and a lack of a deleveraging injection from the sponsors, bondholders will take ownership and control of the business.”
Under the plan, €350m of 5.375% November 2022 SSNs will be exchanged into €220m of December 7.75% (there is a PIYC element under certain conditions) 2025 SSNs and €130m of Holdco PIK notes (12% PIK, 0.5% cash) due September 2026. New money of €30m will come in as a SSN tap and backstopped by the ad hoc bond committee, if a new SSRCF cannot be raised.
Lowen Play is projecting €82m of FY22 and €99m of FY25 adjusted EBITDA (giving net leverage of 6x and 5.5x respectively). Our deep dive in February cautioned that the EV/EBITDA multiple could be as low as 4-5x, potentially leaving the PIK impaired. With the PIK paying 12% (plus 0.5%) the debt balance will grow by another €75m by 2025.
However, the plan assumptions do not reflect any Covid-19 related lockdowns or 2G regulations. Management estimates these will have an impact of c. €25m to sales and c.€17m lower EBITDA / cash from mid to end-November 2021 until March 2022.
Total liquid assets
As part of our sum of the parts in Aggregate series, earlier this week we released a liquidity analysis for the German Real Estate developer, the first in a number of deep dives.
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While its peer Adler has been able to reassure investors with a series of asset and stake sales that its valuations and accounting may be less troublesome than short-seller Viceroy Research had alleged in October, Aggregate from an outside perspective has appeared more desperate, relying on selling assets at a loss and securing rescue deals with peers to stay afloat.
Last week, it was revealed that it had sold stakes in S IMMO the Austrian Real Estate Group, and exited its 10% stake in Corestate, causing a 3–5-point rebound in its bonds into the mid-70s. 9fin’s Emmet McNally believes that while recent asset sales further support liquidity, longer-term financial assets and a recently secured loan from peer Vonovia will not help their near-term situation, with an apparent forthcoming cash windfall from assets held for sale not as it seems.
As well as finding a solution to deal with the May 2022 put on its €300m VIC Properties convertible bonds, near-term liquidity needs include a likely outstanding consideration from the acquisition of the Fürst development from Vivion during H1 21. A short-term debt maturity wall of €600m may prove challenging given the distressed trading levels of its bonds. In addition, its cash generation is well short of what it needed to service debt and fund capex on its development portfolio, with the unwinding of a substantially negative working capital balance (as at Q2 21) another potential headwind.
Overall, we calculate that current liquidity headroom is €350m-€400m short of near-term liquidity needs when excluding short-term debt refinancing requirements. Following its option and loan deals with Vonovia, its Adler Group state will have to be marked down sharply andmay soon be worth considerably less, or nothing to the group.
Following the release of the report, we have established further details on its Fürst development acquisition from Vivion in June and further payments due to its German peer by June 2022. We also believe there are doubts whether the project is funded to completion. Watch out for more updates in the coming days and weeks, including the LTV ratio and the company’s build-to-sell portfolio.
Wishful thinking
A China crisis led by property company defaults appears to no longer affect risk assets outside the region. But is this wishful thinking?
This week Fitch Ratings was the first agency to place Evergrande and Kaisa in selective default, after failing to make $82.5m coupon and $400m bond repayments respectively. The missed payments were inevitable, after months of trying to scrape together funds to meet upcoming obligations, often at the very last minute, with its chairman having to dip into his personal fortune, it was only a matter of time, given much more substantial maturities in March and April 2022 totalling $3.5bn.
Last Friday, Evergrande issued a statement saying: “Since September 2021, the Group has been diligently reviewing its capital structure and liquidity condition with the help of its financial and legal advisors, evaluating all available strategic options, and maintaining ongoing dialogue with offshore creditors. In light of the current liquidity status of the Group, there is no guarantee that the Group will have sufficient funds to continue to perform its financial obligations. The Group is taking a comprehensive view in assessing its overall financial condition, considering the interests of all stakeholders, upholding the principles of fairness and legality, and plans to actively engage with offshore creditors to formulate a viable restructuring plan of the Company’s offshore indebtedness for the benefit of all stakeholders.” It added that it expects an acceleration request on a $260m guarantee.
But the market reaction, for Chinese Property bonds and wider, was a collective yawn. Reuters’ analysis piece, says that investors are less fearful of the implications, with several quotes saying that the contagion risks are low. They appear to be reassured by the smooth landing being prepared by Chinese Regulators, with Robert Armstrong from the FT saying:
The Chinese authorities seem to be trying to do with Evergrande what they did successfully (to date) with the over-extended insurer Anbang: some sort of orderly, break-upy, liquidationy thingy which will not require a general bailout of the sector, or fiscal and monetary juicing of the economy.
This will involve state-owned entities taking Evergrande’s assets and liabilities at prices that will not require big losses to be recognised. The government’s goal is “to reach a balance between short-term stability and long-term reforms”, as Chaoping Zhu, of JPMorgan Asset Management, put it in the Financial Times today.
It has been well publicised that distressed funds have actively bought into property developer debt in recent months. It is one of the few HY/distressed sectors globally which isn’t completely mispriced and given its sheer size there is ample liquidity to trade in and out – it reminds me a little of the hedge fund obsession with Icelandic bank debt in the early 2010s.
The workout of the sector is likely to be complicated, politicised, and messy. Evergrande obligations are huge – at $300bn, it has 1300 real estate projects on the go. It is not just the two companies in the firing line, Fantasia, Yango Group are also likely to default. According to JPMorgan there have been 11 defaults so far, land sales were down 55% y-o-y in October, with housing sales down 25%.
According to some advisors tracking the sector, the investment thesis for buying Evergrande bonds in the low to mid-20s was as simplistic as trying to clip a couple of coupons. This is now unlikely to occur. If a soft landing cannot be engineered, better quality firms hope to refinance might be wishful thinking:
It's time we should talk about it
There's no secrets kept in here
Forgive me for asking
Now wipe away your tears
And if I wish to stop it all
And if I wish to comfort the fall
It's just wishful thinking
Intralot bets on early refi of 2024 SUNs
The last two quarters performance was impressive for Greece-based lottery operator, Intralot, with LTM EBITDA rising by 56.7% to €103.2m versus FY20 as at end-September. This was driven by a strong performance from Intralot Inc, its US subsidiary, whose EBITDA rose by 63.5% in the first nine months of 2021.
Intralot Inc is the largest contributor to EBITDA and generates most of the group’s consolidated cash flow. The North American subsidiaries represent around two thirds of consolidated EBITDA, but only a third of the group's consolidated debt, and therefore have a higher credit quality.
The performance of the US subsidiary mostly benefits the 2025 SSNs, resulting from a controversial restructuring in which the 2021s SUNs exchanged €250m senior notes due September 2021s for new $244.6m SSNs guaranteed by Intralot Inc. The 5.25% 2024 SUNs were offered a partial exchange into 49% of Intralot Inc equity, and to avoid breaching restrictions on secured/priority debt incurrence, Intralot designated the new US topco and its subsidiaries as Unrestricted Subsidiaries. For more details – see our Restructuring QuickTake.
It begs the question whether 2024 holders should have taken the exchange into equity or held out for repayment. Their bonds have rallied sharply in recent months from 60 to just under 90 today, to yield around 10%. LTM leverage is now 4.9x, down two turns from the prior period.
In their conference call this week, management said they are seeking to leverage its US business ‘in the best possible way’ to improve the group’s financial position. This could be done in various ways, including via joint venture partnerships such as in sports betting contracts, they said, without elaborating further. With EBITDA set to return to triple-digit millions by year-end the management team expressed confidence that the 5.25% SUNs due September 2024 could be refinanced early and at a cheaper cost.
What we are reading this week
At 9fin, we are keen at looking at forward looking indicators for distress. With inflated bond prices an unreliable guide, and many businesses reporting based on 2019 numbers and/or including substantial add-backs, there is a need for other metrics. Weil’s inaugural distressed index is definitely worth a look and has given us at 9fin some ideas on how we can use our data to provide leading indicators.
After a series of policy mistakes, Turkey has turned the clock back almost twenty years. Turkish banks are making a fortune from Erdogan’s rate cuts as inflation spirals. They can borrow at the central bank at 15% and buy government bonds at 22.7%. Why bother lending to business and consumers at lower rates? Meanwhile the Turkish Lira continues to slide.
If you thought the spike in natural gas prices and energy prices was behind us, take a look at the following chart for the one-year forward curve:
Bloomberg reported that energy prices on Wednesday hit record highs for Germany and France, as cold weather has forced utilities to burn more coal and gas to meet demand.
And this is feeding into other asset prices such as Fertiliser – remember the closures affecting Co2 supply?
Tech indexes are close to all time highs. They say that a rising tide lifts all boats, but not ARKK.
And for Succession fans: