Exchange dilemmas

Buying back at below par is becoming an increasingly common practice across the leveraged finance market. However, in a move designed to level the playing field for both investors and borrowers, S&P and Moody’s now categorise the move for lowly rated borrowers as an effective default.

The methodology does, however, distinguish between distressed and opportunistic exchanges. S&P treats buybacks from B– or lower rated borrowers as distressed, so making them an effective default. Meanwhile, buybacks from BB– and higher rated borrowers are considered opportunistic, meaning the move does not constitute a default.

Buybacks and exchanges falling between these rating categories are evaluated on a case-by-case basis. Moody’s in turn has categorised a debt exchange from a borrower rated Caa1 and below as distressed and one from a borrower rated B1 and above as opportunistic.

The decision has, if nothing else, proved controversial. For some, the ratings agencies’ move simply reflects the reality that investors who signed a loan in the expectation of being repaid at par are now being offered a take-out at a considerable discount – or a restructuring through the back door.

“We feel that we need to reflect the fact that the company has not lived up to its original obligations. We view such a transaction as being very much like a restructuring outside of the bankruptcy process, thus tantamount to default,” said Ben Bubeck, a credit analyst at S&P.

Others strongly disagree, claiming that debt buybacks benefit the market. “Since last year there have been over 60 debt buybacks,” said Meredith Coffey, senior vice-president of research at the Loan Syndications and Trading Association.

“Buybacks are good for the companies because they help them delever. They are also good for investors, who can choose to sell their loans or not into a tender. No-one is forcing investors to sell their loans,” she added.

Bucky Khan, head of loan sales and trading – Americas at BNP Paribas, agrees, saying: “Buybacks are good as they provide a bid and help deleverage credits. Any account that does not like the bid can just say no.”

The damage done

Critics of the agencies’ move fear that sudden downgrades to the Triple C or D category would only serve to compound the pain that already suffering CLOs are feeling. CLO funds have the ability to hold Triple C debt in pre-arranged buckets. However, if these buckets exceed their allocated weighting then ratings agency action would compel the CLO manager to count that asset at a predetermined liquidation recovery amount.

A drop in the value of the assets could then force a CLO manager to sell assets or face failing an overcollateralisation test. Failing this test would require any excess cash to be used to rebuild asset value, instead of funding equity distributions, paying management fees or even further lending.

“If CLOs have too many SD loans in their portfolios, it can impact their overcollateralisation ratios. This can reduce CLOs’ ability to lend – and reduces the availability of funds for companies. Therefore, the ratings implications could end up reducing liquidity, thus hurting the market and hurting investors,” Coffey said.

Last week, Harrah’s Entertainment joined the increasing number of issuers that S&P has downgraded to selective default from CC after a debt exchange. The decision follows the settlement of Harrah’s US$2.8bn discounted tender offer, which the agency saw as “tantamount to default given the distressed financial condition of the company”. Harrah’s other debt issues were also downgraded from C to D.

This is not the first time that Harrah’s has seen its ratings slashed after an initiative to cut debt. The casino operator faced a similar situation in November last year when it offered to exchange US$2.1bn of senior second priority notes at a discount for portions of its outstanding senior unsecured and subordinated notes. Then S&P downgraded the company to CC from B and adjusted the remaining debentures.

Ultimately, the move on Harrah’s took few by surprise. Indeed, some argued that the gaming concern was so distressed that a downgrade was expected regardless.

In addition, Harrah’s downgrade is not the first time rating agencies have acted on debt exchanges. S&P caused considerable controversy last month when it downgraded Cinram International and Bombardier Recreational Products to CCC+ when they both launched below par buyback amendments. Cinram was further downgraded to SD after it completed its tender offer and followed a previous downgrade to the group’s corporate rating to CCC+ from B.

Think before you leap

The action from Moody’s and S&P is already causing companies with debt trading at distressed levels to think twice before proposing a buyback or exchange.

The B– rated Las Vegas Sands, for instance, had struggled since late March to push through an amendment that would allow it to repurchase up to US$800m of its September 2010 maturing debt.

Investors’ push back was blamed on both the low 5bp one-time fee on offer and the fear that rating actions would damage their holdings as LVS’s corporate rating falls within the distressed debt exchange threshold. That said the amendment finally passed last Wednesday. Goldman Sachs led the transaction.

S&P will now wait to see if the company actually tenders for the debt before moving to downgrade. Last week Sheldon Adelson, LVS’s CEO, said the company had no immediate plans to tender.

The ratings agencies move could also wipe out the tax benefit break included in President Obama’s stimulus package that allows companies that cancel or repurchase debt at a discount to defer tax payments on the difference between the repurchase price and original issue price for five years for re-acquisitions in 2009. The initiative is part of the American Recovery and Reinvestment Act of 2009 signed by Congress on February 13.

Private equity firms, including Apollo, were front and centre in fighting for the provision in the stimulus package. To its misfortune, Apollo also owns Harrah’s.

Michelle Sierra Laffitte