Friday Workout — Joy to Go? Exchanging Contractual Rights
- Chris Haffenden
Wither Volatility.
From bitter experience as a former EM debt trader, I know it can be asymmetric — much lower on the way up as prices grind higher — but can spike sharply on the way down as they crash.
Not that any of this info was built into the symmetrical normal distributions fed into our value-at-risk trading models which determined the size of our trading positions! As vol picked up on the way down, we were forced to sell more into an ever illiquid market.
Reading Deutsche Bank’s Jim Reid’s excellent commentary on Thursday, I was intrigued by the stock market’s reaction to Fitch’s downgrade of the US to AA+. The S&P 500 fell 1.5%, which seems muted, but I was amazed to find it was the largest move since April, an incredible 40 days earlier. A year ago, we regularly saw up or down 2% days, with intra-day moves often a lot higher.
Similarly, the reaction to rises in US Government bond yields, with the 10-year back above 4% (and rising rapidly, to above 4.17% at time of writing), had no effect on the Nasdaq despite the high historical correlation (supposedly due to higher discount rates for DCF models).
The gap now is exceptionally wide.
So far there is a little equity volatility despite the recent rise in bond volatility (MOVE). This is very different to 2022, as stocks got spooked by rises in US Treasury yields.
But we are in August, when liquidity is poor and juniors are manning the desks, which raises the risk that a news surprise could still create a market shock.
There are a few Grey Swans (known events, potentially significant, but rare) out there on the water. Most have created the odd ripple, but have yet to create big waves.
These include the Bank of Japan deciding to tweak its yield control, meaning that Mrs Watanabe might decide to keep her husband’s funds at home, and buy less US Treasuries, just when UST supply is about to rocket. The chart from the FT article in 2020 — What Mrs Watanabe can tell us about how to handle low returns looks very outdated:
So, is the Treasury market able to absorb the surge of issuance, with $1trn of additional debt being auctioned? Probably, but at what cost? All things being equal, according to Barclays, it will result in ‘just’ a 46bps increase in 10yr UST yields, so perhaps not a big a scare, after all.
China’s Japanification might also be worth watching (for the global economy effect as well as for the impact on US Treasury purchases). Perhaps we ascribe too much faith in the Chinese Government to either fix or do the right thing. The size of the problem is certainly huge.
For comparison, the entire US HY market is just $1.15trn in size.
And this week, a test to that hypothesis might have already occurred, with China’s biggest property developer Country Garden asking for “guidance and support from the government” after posting significant losses mostly related to reduced margins and impairment provisions. It said it was considering “various countermeasures to ensure the security of cash flow, including but not limited to reducing various operating expenses, accelerating loan collection arrangements, actively expanding financing channels, and managing and optimising debt repayment arrangements”.
Its bonds are now in the mid-30s, having been in the mid 80s in March.
Whether you agree with me that some form of shock is around the corner or not, on a risk-adjusted basis, I cannot get excited about where risk assets are trading. For example, US HY spreads are sub 400bps, whereas in a recessionary environment they should be at 600-800bps.
And below the hood, credit metrics are increasingly under strain from higher interest rates. While inflation is slowing, this increases the pressure on companies to cut costs to maintain margins as top lines comes under pressure from lower volumes.
According to Pitchbook data, EBITDA growth for US LevFin borrowers has slowed to an average of 5% from 14% (January 2021 to Sept 2022). Per the chart below, leverage is also flatlining, with 17% of their sample having interest cover below 1.5x (likely to be unrefinanceable at current interest rates).
And if you get to the riskier end of the market, it looks even worse, per Moody’s:
And arguably it could be even worse in Private Credit. One of my colleagues in the US spoke to a lawyer who said that five out of 12 of loans he is working on are either in default of their covenants or about to go into default next quarter. Fitch’s excellent US mid-market report reflects this worsening, with a 250bps pick-up in default rates in the first half of this year, and default rates potentially hitting 5% by year-end.
Joy to Go
Unlike private credit, in LevFin some of the default risk has already been mitigated by the raft of A&E transactions, taking advantage of the willingness of CLO investors to entertain 100bps plus margin bumps, often turning a blind eye to debt service capability.
As outlined in this month’s Top of the Flops, at least 35 have been conducted in Europe this year. This leaves just 16 issuers with loans trading at distressed levels (below 85 in price) with maturities before the end of 2025. But many are already in (or expected to enter soon) restructuring processes. This leaves Flamingo, Arvos, Accolade Wines, PlusServer, Veritas and Iberconsa worthy of further investigation.
There could be more rich pickings for advisors looking for restructuring mandates in bonds. Using the same criteria (12% STW for distressed) we get 22 issuers, including names such as Lycra, Atalian, Tullow Oil, Lowell, Schoeller Allibert, Peach Property, Tele Columbus, Boparan, and Pro-Gest; all in our European Restructuring Tracker, with plenty of articles and analysis to boot.
But a little further out, there are number of companies with 2026 maturities trading at stressed and distressed levels which, despite having no immediate triggers, are unlikely to grow into their capital structures.
One example is Selecta, the Swiss vending machine company, which has shown a decent recovery from its Covid-related problems as travel was reduced, affecting its sales at railway stations and airports across Europe.
In 2020, sponsor KKR led a restructuring in which it put in €175m in return for an extension of the RCF from 2023 to 2026, and bondholders agreed to reinstate 64c of their claims into new 2026 first lien bonds at OpCo level and 16c into second lien notes at HoldCo level.
At the time, it forecast deleveraging to below 5x by FY 24, which should be enough to enable a refinancing (it refinanced at 4.5x in 2018, and 5x in 2014/15).
So, is it going to plan?
From a liquidity headroom perspective it is doing well, with €153m available as at H1 2023 (€43.8m cash and €109.5m available from €150m RCF), but from a leverage perspective, it has a long way to go, with senior secured leverage at 5.6x, and 7.5x total. Adjusted EBITDA margins rose 1.8% to 18.9%, ahead of the 16% projected under the business plan.
The improved cash position appears to have driven mostly by sharp drops in Capex, which has fallen sharply from levels seen in 2018 and 2019, and at around €60-€65m annually, is below the c.€110m as envisaged under the original business plan and is just 4.3% of sales.
I’m not sure if growing Foodtech — intelligent vending, and replacing underperforming machines and contracts, while signing deals with amusement parks and rolling out sponsored Mars M&M machines — will be enough to generate a higher multiple for its long suffering owners.
But I should give some kudos to management for trying to enliven the business in their presentations, delivering millions of moments of joy for customers — Joy to Go
And the company’s bondholders are feeling more joyful too.
The 2026 SSNs are yielding 11.75%, on the cusp of a stressed refi, but the second liens are struggling to hold above 70, around a 25% yield, reflecting the likelihood that they could be compromised in yet another restructuring, made much easier to jettison, given the OpCo/Holdco structure.
Exchanging Contractual Rights
Regular readers will know that we’ve been spending a lot of time on German Real Estate of late, culminating in our special report — now available beyond the paywall here.
Our follow-up plan was to revisit some of the names for deeper dives. Vivion and Accentro were top of our list, and we had done some initial work, but events have caused us to change tack.
Vivion’s exchange offer earlier this week caught us by surprise. As 9fin’s Emmet Mc Nally says in his analysis of the offer, it raises a number of questions on whether holders (in particular the 2024 SUNs) participate or not. For a legal analysis of the exchange click here
With no mention of the 2024s being part of the “indicative supporting holders” — which btw sounds a little flakey to us, why not secure lock-ups in advance? — the proposal appears to have been structured with help from cross-holders of the 2025s SUNs and converts.
Do the 2024 holders participate by 10 August to get the 20% upfront payment (which subsequently disappears) and exchange the remainder into what is likely to be non-par senior secured 2028 bonds? Or stay in a stub and remain in front of the maturity queue for their bonds which go current on 8 August?
The new 2028 notes pay a cash coupon of 6.5% plus PIK interest of 1.25% in Year One, 1.5% in Year Two, 1.75% in Year Three, 2% in Year Four and 2.25% in Year Five.
The 2025 SUNs are similarly extended with the same interest rates into 2029 SSNs with a 10% cash early bird payment, but there will also be a consent solicitation that would make the 2025 SUNs exchange mandatory, which suggests a stub here is unlikely.
The 2025 converts could be the main beneficiary of the plan as their bonds are exchanged into the new 2028 notes — a proportionally higher coupon, and a shorter maturity extension.
But as Emmet outlines, while in theory they gain security, in practice they “would be in a structurally weak position, sitting at Vivion Investments HoldCo level. What this means is that they remain structurally subordinate to AssetCo level or PropCo level secured and unsecured debt, and €461m of outstanding minority GCP shareholder loans. They would, however, rank contractually senior to any stub 24 SUNs in any subsequent credit event, and this stub quantum could be large if only some holders opt to exchange”.
Our view is that this exchange offer is not a par exchange and we would expect the new notes to trade at a discount, using Adler Group as a comparable.
Bullets from our analysis are reproduced below:
- All-in yields look tight given credit profile and market conditions
- Yields tight to other German Real Estate companies
- The exchange is structured on stale FY 22 numbers which understate LTV and other credit metrics
- We estimate EPRA-guided FY 22 LTV of 55.5% vs 37.5% company reported; the ratio increases further pro forma the transaction
- Cash looks very thin at Vivion Investments level post-settlement, suggesting there is an almost immediate need to upstream more cash
- Upstreaming cash from Golden Capital (GCP) requires pro rata repayment of minority shareholder loans, increasing the cash burden markedly
- We estimate there’s only two years of cash runway at GCP to fund debt servicing at Vivion Investments
- PIK interest accrual will add to the debt quantum by the 2028 SSN maturity and further strain credit metrics
- We estimate there is a €450m cash shortfall at GCP to service the SSNs
- 2024 noteholders could opt not to exchange, and if they are in a small minority it might work, but otherwise the risks are many
The exchange has prompted a response from Muddy Waters, whose report can be found here. I particularly liked this (refers to use of hotels for refugees):
On a more serious note, look out for further analysis on Vivion in the coming days/weeks.
In our piece on Accentro in August 2022, we highlighted that sponsor Brookline took out a €100m loan from a South Korean Bank called Nonghyup in July 2020. From the Luxembourg company register, we noted that this loan was due to mature in July 2022. At the time, we said, “It is unclear as to whether this has been repaid or extended. As Brookline’s stake in Accentro is its largest asset, it may have to be pledged against this loan.”
Brookline (via Vestigo Capital Advisors, linked to Azeri businessman Natig Ganiev) had bought an 80% stake in Accentro from Adler in 2017, but only paid 20% upfront. Adler recorded the rest as a receivable and continued to extend its maturity, with €97.9m paid in the 2019 financial year. It eventually wrote-off the €60.4m due to be repaid by July 2022, saying it was unrecoverable.
In March, the group’s €250m 3.625% 2023 senior unsecured notes (SUNs) and €100m 4.125% 2026 private placement notes were extended by three years to 2026 and 2029 and its coupons were increased by 2% to 5.625% and 6.125%, respectively. The notes were also secured against shares and receivables in various Accentro entities. The full terms of the amended 2026 and the 2029 bonds can be found here.
But now, following a default on the loan, which Accentro confirmed in late July was secured against a 75% shareholding, NongHyup Bank Co is set to become majority shareholder after enforcing on its share pledge. In addition, it is considering “implementing certain corporate governance changes and initiating an equity or equity-like fundraising in the mid two-digit million range to provide additional liquidity to the company and partially repay the €225m outstanding SSNs, maturing in 2026”.
But this requires a waiver from bondholders of the CoC clause, and some conditions under the bond docs such as guaranteed minimum redemptions, as it is unlikely that it will meet the €40m payment due under the extended bonds by December. As Bianca Boorer reports, “Given the general state of the German real estate market asset sales will be a challenge,” a source close to the company said. “Any possible sales would be at a major discount.”
The lack of transactions and for those which do occur, their discounts to book valuations is a common theme for the German Real Estate sector.
Those who don’t have to sell are advised not to. But an increasing number of companies with EHY bonds and upcoming maturities may not have this option — which may explain the rationale for the recent Adler Group, Accentro and now Vivion extend-and-pray transactions.
DIC Asset’s latest earnings release shows how just how difficult the market is for RE borrowers.
It operates a yielding real estate portfolio alongside mutual funds in Germany, and, as 9fin’s Hazik Siddiqui writes, is balanced on a knife edge.
There are €806m of upcoming debt maturities compared to €486.7m of pro forma liquidity. LTV and interest coverage covenants are likely to be challenged later this year amid property devaluation and coupon step-ups on its VIB bridge financing — after its terms were recently renegotiated with bridge lenders. The extension provides breathing space to sell yielding assets in a more controlled manner and avoid a fire-sale situation. This, however, comes with a price as there are multiple margin step ups until final maturity.
But, to achieve this, it has to hit the higher end of its €300m-€600m of asset sales target in 2023.
Four properties were sold in H1 23 with a total notarised value of €132m. This included three assets worth €119m from the yielding portfolio, and an additional €13m property from the “RLI Logistics Fund – Germany II” special fund.
DIC booked an average discount of 13.6% on these transactions. Despite double digit mark-downs, DIC expects a property devaluation of just c.4% to 7% at year-end.
The CEO tried to reassure investors on the call, saying that the sale discount for the largest asset was a one-off, as it had a number of ESG issues and required significant capex spend, leading to a strategic decision to sell.
Let’s hope this is the case, as DIC Asset has used up almost all of its secured debt capacity, so has little collateral to offer, and while in compliance with covenants, its headroom is expected to be very tight by year-end. We estimate that a 7% decline in valuations gives just 1.82% LTV headroom, and interest cover could be even more challenging.
In brief
Lycra’s innovative drop down transaction might have been too much of a stretch for its 2025 bondholders. This week, presumably backing down from legal threats, they removed the drop down feature. The priming transaction remains, but the collateral is returned and language tightened to stop this happening again.
According to local media reports Pro-Gest has received offers for some of its Italian plants, which might help its deleveraging efforts to refinance its 2024 bonds.
Groupe Casino snuck out a presentation late last Friday detailing the agreement in principal on its restructuring plan — look out for our upcoming analysis on the revised deal
GenesisCare is likely to be sold piecemeal rather than as a going concern, company counsel Lindsey Blum told a Texas Court. When asked by Judge David Jones what she thought the most likely outcome of the company’s marketing process would be, Blum told the court that a sale of the oncology hospital assets grouped by geography was most likely to maximise value.
An interesting tidbit from Moody’s on the Keter consent to extend maturities. It has appended a limited default after the “missed repayment of its €102.1 million senior secured revolving credit facility (RCF) due 31 July 2023. “On 13 July, Keter signed a lock up agreement with the majority of its lenders whereby – among other things - it obtained a forbearance on the repayment of the RCF beyond the three days of grace period. The limited default designation will remain until the company resolves the missed RCF repayment by extending its original maturity date.”
Probably just a irritant for CLO holders with Moody’s ratings, but should be resolved once deal is done.
And finally, next week is set to be a big one, with both Altice complexes set to report, and Drahi set to make a special appearance on both conference calls. Media reports suggest there is progress on data centre sales, and an unsolicited bid for the Media biz at around half of the company’s valuation. 9fin’s Nathan Mitchell provides an earnings preview here.
What we are reading/watching this week
I’ve already given away a chunk of my reading material this week above, but it was a week of cracking content from my wider journalist colleagues.
Such as Reuters analysis of Argentina, and China holding the key to avoiding a default on IMF debt and another $7.5bn of financing. Will it avoid going into double-figures on debt defaults?
I would love to write the screenplay to The Sunshine Millionaire: How one man took £130m from British Taxpayers from the Bureau of Investigative journalism, the story on how Thurrock Council defaulted on £500m of borrowed debt to fund purchases on inflated solar farms.
When you’re so big that $2bn of defaults are a rounding error on $825bn of assets.
As Twitter gets rebranded as X, the WWF sees an opportunity to protect our wildlife:
As we enter the holiday season, it is a time to forget our troubles and our structural deficiencies compared to our US cousins:
On 1 September, Brighton will find out who is in their Europa League group and fans can dream of away days to far flung places such as Lisbon, Rome, Villerreal, Toulouse, Atalanta or Leverkusen.
Or the Faroe Islands! Congrats to o KÍ Klaksvik who have made it through qualifying round of the Champions League. If they lose, they would drop into the Europa League. This is their stadium: