EFH and Oncor: An Electric Ring-Fence

TXU's 2007 LBO by KKR, TPG and Goldman and its subsequent bankruptcy filing on April 29th serve as an informative case study of the evolving nature private equity investments, commodity bets, various facets of the public utilities industry, and a complex, debt laden capital structure. S&P has a great recap of the events leading up to Energy Future Holding's filing; go here to read it. Also, check out this free webinar by Chapter 11 Cases to be held on 5/8 at 1pm ET. 

What piqued my interest in this filing was the ring-fencing of Oncor, which obviated the subsidiary's need to file for Chapter 11 protection. Ring-fencing of a subsidiary is typically done by declaring a unit as a bankruptcy-remote entity (also known as Special Purpose Entity or Special Purpose Vehicle). Here's more: 

"'Bankruptcy-remote entities' have been utilized for years in commercial transactions as a means to protect a defined group of assets from being administered as property of a bankruptcy estate in the event of a bankruptcy filing by an affiliated entity." Crowell Moring

Oncor, which is regulated transmission and distribution entity that is 80% owned by EFH, was ring-fenced at the entreaty of Texas Public Utility Commission (PUC). 

"At the time of the merger of TXU Corp, EFH and Oncor made significant commitments to the Texas Public Utility Commission regarding the separateness of Oncor from EFH.  These commitments, commonly referred to as Oncor's "ringfence" are included in Oncor's governing documents as well as an order of the Public Utility Commission of Texas which carries the weight of law." Oncor Website

It seems that the strategy worked: Oncor's collateral should not be used to pay EFH's debt. But that doesn't mean that the ownership of Oncor would be unaltered. 

Post bankruptcy, some unsecured creditors including Avenue Capital, P. Schoenfeld Asset Management and GSO Capital could end up owning Energy Future Intermediate Holding Co (EFIH) and become the newly adopted parents of Oncor. A change of control like this would likely trigger a need for regulatory approval from Texas PUC to ensure that the modification would be in public interest. Moody's notes that this change of control may also come with a push for a rate concession during a public interest hearing. (Reuters)

A tax-free spin-off of EFIH, however, would not necessarily be a credit positive for Oncor. 

"EFIH is expected to have about $5.4 billion of debtor in possession first-lien senior secured debt, and is likely to carry an additional $1.9 billion of second lien DIP debt backed by its unsecured creditors. In effect, this debt means there will be little deleveraging at EFIH during the restructuring process, and Oncor, as the only unit generating any revenue or cash flows, will ultimately be looked on to provide upstream dividends and tax payments to service the debt load. That said, the EFIH second lien DIP debt is structured as a mandatory convertible, so upon emergence, the unsecured debt will convert to equity, a credit positive." Electric Light and Power

While the spin-off sounds like an overall positive event for Oncor, one has to keep in mind the possible rate renegotiating that could take place as a result of the PUC hearing. Moreover, about 26% of Oncor revenues come from Texas Competitive Electric Holdings (TCEH), an indirect subsidiary of EFH and included in the Chapter 11 filing. (Oncor 10Q) So there is some revenue risk for Oncor to the extent that TCEH has trouble during the restructuring process. That said, post EFIH bankruptcy emergence and mandatory convert of the DIP to equity, Oncor's earnings and leverage profile look strong.

What does this mean for the Oncor bonds? They're okay for a high grade investment since they really lack the juicy yields we're used to, but they could be a good alternative to cash.  The '32s and '33s are yielding over 125 bps in spread, but the dollar price is in the $130 range. I would rather be in the 5.25% '40s with spread of a little over 100.

One last thing: Don't try ring-fencing at home! (Okay, maybe you can, but get a lawyer first). Bankruptcy remote entities aren't necessarily bankruptcy proof. In 2000, Doctor's Hospital of Hyde Park, which had set up a "bankruptcy remote" vehicle called MMA to purchase the hospital's receivables, filed for Chapter 11. The Seventh Circuit disagreed with the nature of MMA's separateness, which called into question the Hospital's transfer of receivables to MMA. 

"The bankruptcy judge made clear that a court should go beyond evaluation of the documented list of “separateness factors,” and examine whether the behaviors of the related entities are consistent with their purported “separateness.” The court further noted that when analyzing whether an asset transfer is a “true sale,” courts should carefully examine the true sale case law elements to see if they have been actually satisfied by the transaction." The Insolvency Blog

Betting on Casinos, Part II

Let's Take this Online

My last post discussed how the debt at Caesars operating company relates to the entity that carries the online gaming  business. In this post, I want to talk a little more about the online gaming business and how it specifically relates to Caesars. 

The Turnaround Management Association's January 2013 issue of Journal of Corporate Renewal was dedicated to managing casinos through a restructuring. It's worth a read in its entirety for those investors or professionals interested in the gaming industry. One of the interesting things discussed in that issue is the role of the legal system in online gambling. The article explains that both the Illegal Gambling Business Act and Unlawful Internet Gambling Enforcement Act are "inapplicable if a bet is not unlawful under federal law and the law of the state from which the wager was made and received." TMA

Apparently, the politics surrounding online gaming laws are pretty obfuscatory. Internet gaming is legal in Delaware and New Jersey, and Nevada only offers poker to its online customers. 

"At least 10 states are considering legalizing Internet gaming this year. Some are further along than others. Positive sentiment has been expressed in Massachusetts and Illinois statehouses, a poker-only bill was introduced in New York and California’s poker-only legislation is slowly moving forward." Las Vegas Review-Journal

"Las Vegas Sands Corp. Chairman Sheldon Adelson — who has vowed to dip deep into his heavy wallet and spend whatever it takes kill online wagering — funded the Coalition to Stop Internet Gambling. 

Not to be outdone, MGM Resorts International, Caesars Entertainment Corp. and the American Gaming Association are paying the bills for the pro-Internet gaming Coalition for Consumer and Online Protection. 

Apparently, some lobbyists sold themselves to the highest bidder.

As reported this month by political pundit Jon Ralston, Bono initially offered to work for Adelson’s side before joining the pro-online gaming forces. Meanwhile, Dickstein Shapiro, a large law firm with a lobbying component, initially pitched its services to Caesars before signing on with Adelson." Las Vegas Review-Journal

This sounds so Godfather-ish.

Okay so near-term prospects of legalizing online gaming don't look promising. 

Let's get back to Caesars. The gaming company was acquired by Apollo and TPG in January 2008. The funding for the acquisition resulted in $21 billion of debt at Caesars Entertainment Operating Company (CEOC). Then, in October 2013, the parent company of CEOC, Caesars Entertainment Corp (CZR), formed a joint venture Caesars Acquisition Company (CACQ) to form Caesars Growth Partners (CGP). Then, CZR contributed all of the shares of Caesars Interactive Entertainment (CIE) along with other assets to CGP in exchange for $360 million of proceeds. CIE has all the internet gaming assets. Here's another version of the company's capital structure. (Caesars Exchange Offer)

In the last post, I discussed the capital structure issues with investing in CZR, namely that parent still guarantees much of the debt, giving the guaranteed debt priority over the CZR stock in case of an operating company bankruptcy. CEOC was levered around 15x at the end of 2013 (Caesars supplemental financials). But what if you wanted to invest in CACQ stock as a way to have online gaming exposure?

According to the CGP Offering Memorandum dated April 10, 2014, CACQ has 42% of economic interest in CGP, which owns CIE. CZR has 52% of economic interest in CGP. CGP owns casinos Horseshoe Baltimore, Plante Hollywood, The Quad and Harrah's New Orleans. 

CACQ expects CGP annual adjusted run-rate EBITDA to be $287-320 million; 2013 adjusted EBITDA pro-forma for the transaction was $238 million. 

Debt at CGP the end of 2013 pro-forma for the transactions was around $2 billion, mainly comprised of $1.16 billion of terms loans, which are guaranteed by CACQ and most subsidiaries, and $675 million of unsecured debt. (Offering Memorandum). 

With a 42% share in debt and EBITDA of CGP, CACQ would be levered at about 6.7x, which doesn't sound so bad. But market cap of the stock is already $1.71 billion, making enterprise value roughly $2.5 billion (add 42% of debt, subtract 42% of cash to market cap), and EV/EBITDA multiple becomes closer to 20x. WYNN and LVS are around 15x and MGM is around 12x. So using the company's projected earnings and assuming steady debt, the stock looks pretty rich.

Betting on Casinos, Part I

One of my friends sent me a Barron's article on Caesars' stock from last week and suggested that it would be a good topic to discuss. It is indeed a good topic because it involves a farrago of issues such as equity valuation, a complex capital structure and an alleged distress situation.

"Caesars (ticker: CZR), which has been gearing up for legalization, has one of the leading brands in its World Series of Poker. Yet the shares look overpriced because the debt-laden company has little going for it besides a future in online poker. Its current market value of about $2 billion assumes legalization of online poker at state and federal levels and significant profits from what is likely to be a very competitive business." Barron's

The company only issued 1% of its outstanding stock in it's IPO, and Barron's claims that volatility in stock price and the alacrity with which shares were scooped up is due to a scarcity of supply. 

Importantly, the company is encumbered by so much debt that any equity value would be elusory. 

"There appears to be little or no equity value in Caesars' core business given the ugly financials. Yet the IPO prospectus shows Caesars carved out its online business, including the World Series of Poker, into a separate unit unencumbered by debt. This means Caesars equity holders should get all the online profits; hence the investor focus." Barron's

There are two issues that I have with betting on the online gaming business for Caesars: 

1) Just because the online gaming business is in a separate unit that is unencumbered by debt does not mean that its proceeds cannot be used to pay for the debt that has a parent guarantee. 

2) I'm not sure if online gaming is as lucrative as the gaming industry would have us believe. 

I'm going to discuss the first issue in this post and the second issue in the next post. For starters, here's the organization structure according to Caesars' website in a presentation dated December 4, 2013:

Notice that the public shareholders hold shares in the Parent company, Caesars Entertainment Corp. The online gaming portion is held in a separate entity called Caesars Interactive Entertainment, as the Barron's article stated. 

"Caesars Interactive Entertainment, Inc. ("CIE"), which is a majority owned subsidiary of CGP LLC, operates an online gaming business providing for certain real money games in Nevada, New Jersey, and the United Kingdom; "play for fun" offerings in other jurisdictions; and social games on Facebook and other social media websites and mobile application platforms, such as Slotomania. CIE also owns the World Series of Poker ("WSOP") tournaments and brand, and licenses trademarks for a variety of products and businesses related to this brand." CZR 2013 10K 

So let's break down the debt level at various subsidiaries. According to the Prospectus Supplement for CZR Stock, CEOC has $15.8 billion of debt, CERP has $4.6 billion of debt and CGP has $721k of debt. Total debt on CZR's balance sheet, therefore, is a little over $19 billion. CGP has an additional $1.1 billion of debt that is associated with a recent acquisition of four properties from the Parent. 

Even though CIE does not have any debt outstanding, that does not mean that all of its earnings go to public shareholders. The reason is that the shares are issued at the Parent level or Caesars Entertainment Corporation (CZR). Moreover, of the $19 billion of debt listed on the balance sheet, at least $15 billion of that is stated in the prospectus as Guaranteed by the Parent or Guaranteed by the Parent and certain other subsidiaries. What that implies is, in the case of a bankruptcy, at least $15 billion of debt is still considered an unsecured obligation by the parent and is still ahead of the equity claims. 

Now that we know that there really is a substantial amount of debt ahead of the equity, the shares can be valued on the likelihood of the Parent being unable to meet its debtors' obligations. 

There is some real concern of Caesars being able to meet its debt obligations. Caesars' latest sale of four casinos to CGP has raised some eyebrows. 

"Caesars Entertainment Corp. (CZR)’s $2.2 billion property sale to an affiliate raises the chances the world’s most-indebted casino operator will force a restructuring of its bonds at a loss to investors.

By selling four casinos to Caesars Growth Partners LLC, the unprofitable company will receive proceeds that Chief Executive Officer Gary Loveman said will help pay down loans. That may help the company persuade those lenders to amend its credit agreements, allowing it to restructure high-cost bonds on more attractive terms, according to CreditSights Inc.

This week’s transaction means the operating unit “will have far fewer assets in Las Vegas where the market is improving -- it will be left with Atlantic City assets where the market continues to basically tank,” Kim Noland, an analyst at Gimme Credit LLC, said in an e-mail. Anticipated future steps will include a distressed-debt exchange and possibly the removal of the parent guarantee." Bloomberg

And the bondholders aren't sitting idly by. Second-lien bondholders of Caesars Entertainment Operating Co., such as Canyon Capital Advisors, Oaktree Capital Management and Appaloosa Management (which, full disclosure, is my former employer), have sent a letter to Caesars Entertainment Corp that alleges that its operating unit is insolvent and that some of its intercompany transactions constitute fraudulent transfers. 

"Still, if the second-lien bondholder group formally litigated and succeeded in court, the lenders could simply get their money back, which wouldn't be a very rewarding result.

In a worst-case scenario, however, CEOC could file for bankruptcy, in which case the new lenders' claims could be subject to a stay and could be invalidated." The Deal Pipeline

If the bondholders are right and CEOC is insolvent, files for bankruptcy or restructures, CZR could be on the hook for making its guaranteed debt as close to whole as possible. Thus, the equity value could be diminutive considering the $15 billion of debt that is guaranteed by the parent is issued by CEOC.

The other obstacle for the stock could be CGP which wholly owns CIE, the unit with the online gaming business. CGP also has a substantial amount of debt associated with it, $770 million of which is on the balance sheet and $1.1 is billion associated with acquisition of the above properties. That debt is an unsecured obligation of CGP, so if CGP has to restructure, any equity that would have been generated from CIE would also be diminished. 

Thus, I think pricing CZR stock is less of an exercise in valuing the online business and much more of an exercise in valuing CZR's subsidaries that have issued bonds with Parent guarantees. 

Bankrupt Companies and their Employees: Conscious Uncoupling

I know, the phrase "conscious uncoupling" is extremely trite by now, but even The Economist joined in on the joke, so I thought, "why not"? Plus, it's actually relevant to this post, I promise.

Brookstone, a specialty retailer of luxury gadgets like massage chairs, has filed for bankruptcy with a deal to sell its assets to Spenser Spirit. The retailer has been cutting costs for a while, however, and it appears that many of the personnel cuts have happened prior to the announcement.

"Jim Speltz, Brookstone president and CEO, said the deal would have no impact on customers, that "business will continue uninterrupted," and that all existing customer programs, including warranties, gift cards, returns and exchanges, would be honored.

The company also plans to maintain employee benefit and payroll as they currently exist, he said. Brookstone's largest creditors support the deal to salvage the retailer that has seen declining sales in recent years." NH Union Leader

Not only are the current employees being retained, but Brookstone is handing out large bonuses to some of its management team. 

"Under the proposal, four executives would earn bonuses tied to the sale price as well as the company’s cash flow. For example, if Brookstone closes the $147 million deal currently on the table, then the executives would share roughly $840,000 in bonuses, although this doesn't take the cash-flow targets into account.

Another 33 non-executive employees would share up to $1.28 million in bonuses as long as they stick with Brookstone throughout the sale process. These employees come from the company’s finance, e-commerce, human resources and other departments." WSJ Bankruptcy Beat

It looks like Brookstone is doing a decent job of transitioning its employees, which is not always the case for companies in distressed situations. Not having an acceptable transition period for the employees could impact shareholders or even sponsor private equity firms!

The WARN Act, which was codified in 1998, gives guidance for lay-offs for both healthy and stressed companies. 

"The WARN Act "provides that a business enterprise that employs 100 or more employees must provide at least 60 days advance written notice of any “plant closing” or “mass lay-off” to each employee who will be terminated.  A “plant closing” is a shutdown (permanent or temporary) that results in the loss of employment of 50 or more full-time employees at a single site of employment.  A “mass layoff” is the loss of employment of 500 or more people or the loss of employment of at least 50 employees constituting more than 33 percent of the full-time employees at a single employment site." JD Supra

Although employers must still provide notice as soon as practicable, there are three stated defenses to the 60 day notice requirement under the WARN Act:

1. "when an employer reasonably believes that advance notice would impede its active pursuit of capital or business;
2. unforeseeable business circumstances; and
3. natural disasters.

Somewhat naturally, companies seeking bankruptcy protection are often forced to abruptly terminate employees before providing the required notice.   In addition to developing the “liquidating fiduciary” principal discussed above, bankruptcy courts have examined, and often disagreed, about certain applications of the WARN Act once the “employer” is bankrupt."  JD Supra

When a company lays off workers in turbulent times, the second defense of the WARN Act may apply, in which case, the company may not have liability under the Act. However, it gets interesting if that company is owned by a private equity sponsor.

In 2000, Outboard Marine Corporation, a designer and manufacturer of outboard motors, filed for Chapter 11 protection and laid off 6,500 employees without notice. Employees filed a class action lawsuit (Vogt case) alleging violation of the WARN Act. However, since Outboard had limited assets, the plaintiffs sued the three private equity firms, Greenmarine Holdings, Quantum Industrial Partners and Quantum Industrial Holdings, along with entities that owned interest in those firms. Goodwin Proctor.

The court determined that those three private equity firms and Outboard constituted a single owner since majority of the shares and board seats were held by those private equity firms.

"The Court focused on the fact that the defendants were heavily involved in the preparations for Outboard’s bankruptcy and ultimately made the decision to file for bankruptcy and close the company’s facilities. The Court concluded that these allegations supported the plaintiffs’ contention that the three private equity firms acted as a single employer and thus could be held liable for Outboard’s failure to comply with the notice requirements of WARN." Goodwin Proctor.

When we think of distressed private equity firms instituting a turnaround of their portfolio companies, lay-offs and closings can be part and parcel of the reorganization. When implementing a personnel restructuring, sponsors need to balance being transparent about cuts and avoiding operational distractions. Moreover, restructuring professionals advising a company in distress ought to tread lightly and make sure that all of the boxes are checked when recommending downsizing. In order to avoid liability under the WARN Act, and even more importantly, to treat employees in a decent manner, a "conscious uncoupling" is crucial. 

Comedy in Tragedy: The Daily Show on GM Liabilities

I LOVE The Daily Show. Last week, Jon Stewart discussed how the post-bankruptcy GM is immune from liabilities related to accidents caused by vehicles made by pre-bankruptcy GM. The automaker's fledgling CEO Mary Bara led the recall of approximately 2.6 million vehicles with faulty ignition switches. This defect is linked to at least 13 deaths, which is especially controversial because GM has known about this since 2005. The automaker purportedly decided against fixing the problem then because it would take too long and cost too much money (WSJ). 

Here's the Daily Show clip: 

The Daily Show
Get More: Daily Show Full Episodes,Indecision Political Humor,The Daily Show on Facebook

Let's recall a teeny tiny fact about the time-frame of the initial discovery of the ignition issue: the GM and Ford downgrade from Investment Grade to High Yield! Remember that mess in 2005? GM and Ford, which were considered bellwether bonds making up the second and third largest issuers of the bond market. This was right after the Fed had raised short-term rates and GM had failed to get healthcare concessions from its unions. 

"The GM downgrade could cause disruptions in the market for junk bonds, partially because many funds that are limited to investment-grade assets will be forced to sell GM's bonds." WSJ

So cost of capital for GM went from around 5% to around 11% for corporate debt. There was a huge sell-off in the bond market and then Kerkorian started bidding for GM stock, which had languished from $40 in the beginning of 2005, at $31. 

I'm sure that GM management at the time was like, "Eh. We have to pay more than double to borrow money, our unions want way more in healthcare benefits than we can afford, and, oh, we may now have an activist shareholder hovering over our shoulders. We're selling a record number of vehicles because we started this vicious employee discount cycle to offset our dwindling market share, and we need to keep selling. Let's hold off on making changes to this ignition thing until we're super duper sure about what we're going to do." Not that it absolves anyone of wrongdoing, but it gives us some context as to the turbid morass that the company was in at the time. 

Okay, so let's get to the liabilities from ignition device defects, why, according to bankruptcy law, new GM doesn't necessarily have a legal obligation to compensate consumers for the malfunctions, and what can possibly be done about it. 

When I heard Stewart talk about GM negotiating the release of former liabilities as part of its bankruptcy plan, he made it sound as if such releases are abnormal. In fact, a Chapter 11 filing is puissant precisely because it gives the company a new life line by extricating itself, at least partially, of the heavy burdens of debt and liabilities. If you'd like to know more about the history and impact of liabilities releases on financial renewal in America, check out this ABI podcast with Harvey Miller.

When a corporation files for bankruptcy protection, a reorganization plan, which has to be approved by the judge, details recuperation of the company's assets for all stakeholders. BUT, all stakeholders aren't created equally. For example, in GM's case, if a bank lends specifically for the a new plant and the plant serves as collateral, more than likely, in a simplified case, the bank will get that plant in a bankruptcy filing. This arrangement makes the bank a secured lender. 

Then, there are unsecured lenders, those who lend to GM without having explicit collateral. There are many levels of unsecured lenders, which can get kind of complicated. But the process of a restructuring involves figuring out which lender has dibs on which assets, and then distributing those assets accordingly. 

Obviously, consumers of the product can also have claims in a bankruptcy proceeding, especially in cases such as warranties, gift certificates or pre-orders. So what happens in the case where stakeholders at the time of the bankruptcy don't know they're going to have claims? That is, they didn't know they had a faulty switch until now in a car that was purchased back before the bankruptcy filing? There is precedence for such a situation in the Epstein v. Official Committee of Unsecured Estate of Piper Aircraft. Here's a quick summary: 

"Piper has been manufacturing and distributing general aviation aircraft and spare parts throughout the United States and abroad since 1937.

On July 1, 1991, Piper filed a voluntary petition under Chapter 11 of Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Florida. Piper's plan of reorganization contemplated finding a purchaser of substantially all of its assets or obtaining investments from outside sources, with the proceeds of such transactions serving to fund distributions to creditors.

On July 12, 1993, Epstein filed a proof of claim on behalf of the Future Claimants in the approximate amount of $100,000,000. The claim was based on statistical assumptions regarding the number of persons likely to suffer, after the confirmation of a reorganization plan, personal injury or property damage caused by Piper's pre-confirmation manufacture, sale, design, distribution or support of aircraft and spare parts." 58 F. 3d 1537

The most relevant aspect of this case decision is that these Future Claimants are considered tort victims. The problem is that tort claims do not take priority over secured claims, meaning that they're in the same category as unsecured claims. LexisNexis

So, let's do a simplified hypothetical example. The bank lends GM $80 for the plant. Then, GM issues unsecured bonds that get purchased by mutual funds and insurance agencies with a notional amount of $100. Total GM debt is $180. GM files for bankruptcy and sells its plant and other assets for $100. Of that amount, $80 goes to the bank because it was a secured lender. There's only $20 left over for ALL unsecured bondholders plus any future claimants of tort cases. The trustee sets aside $10 for future claimants and distributes $10 to the rest of the unsecured holders. 

A few years later, it turns out that there are $100 of tort cases related to pre-petition design of cars. New GM pays off those victims in full. What happens? If you held an unsecured bond and 10 got cents on the dollar, you'd be pretty upset since the tort victims, whose claims were at the same level as yours, got more than you did. 

The problem here is deeper than it initially seems. If we assume that future tort victims have similar priority as unsecured claimants, then we can't justly pay them more. We also can't require the new GM to compensate the tort victims because that would be changing the rules after the deal has been done. That is, since the new GM has different shareholders, the new shareholders bought the stock assuming that they weren't liable for future claimants any more than for unsecured bondholders. Changing that would cause buyers to lose trust in the system. (Here's a Pepper Hamilton article for more). 

The current law obviously isn't the answer, however. Loyola University's Law Journal describes the issue in more detail: 

"Allowing the debtor to escape liability for wrongful prepetition conduct frustrates the goal of deterring wrongful conduct by the debtor and others in the future. Under Piper, a tortfeasor may escape financial responsibility by simply filing for the protection of the bankruptcy court."

Is there a solution? There have been many offered in the legal field. Future damages that result from pre-petition issues could be considered claims in the bankruptcy court. There can be a cap on those claims and the judge can decide on a case-by-case basis. 

Another solution may be to put an actual dollar amount estimate to future claims and considering them secured debt so that they receive a portion of what's due to the secured guys. Here, the secured debtors end up paying for the victims (you know, the lender for the plant). 

Another answer could be explicitly requiring the new shareholders to pay for the mistakes of the old GM, maybe with a cap, so that the new shareholders know what to expect. 

Lastly, there could possibly be a claw-back using the fraudulent conveyance argument from previous shareholders, which may be the most fair, but also the most difficult to prove and execute. 

See Mr. Stewart, the problem here isn't simply a matter of whether or not the injured ought to be compensated; it's a problem of who pays for it and ensuring that the decision is the most just solution available. 

'Amend and Pretend' or 'Fake it 'till you Make it'?

It seems as if any time companies aren't defaulting in droves, they are "amending and pretending". That is, companies renegotiate covenants and borrowing terms with their lenders to obviate a technical default that would lead to a larger restructuring. 

The Wall Street Journal's Bankruptcy Beat Blog has a new section in which bankruptcy and restructuring professionals opine on a chosen topic. The first one question proffered to the experts was essentially: isn't corporate restructuring on life-support because of low interest rates and maturities being pushed out to 2017 and 2018? I'd encourage you to read the post and the contributors' assessments because they provide a panoply of viewpoints on the matter. You can read all the posts here.

Many argue that companies issuing high yield bonds or leveraged loans have too much debt, and they can only service the debt because lower rates result in low cash interest expense. If you read LCD, you'll see the data corroborating this hypothesis. For example, even with lower rates and higher prices for syndicated leveraged loans, much of the new issuance is "covenant-lite", meaning the credit agreements lack financial metrics that companies must meet at certain intervals. The prevalence of cov-lite loans, along with low rates, was identified as one of the drivers of over-levered corporations. LCD points out, however, that the supply of cov-lite loans as a percent of the loan market is higher now than it was in 2007. Additionally, a greater percent of the loan market is rated CCC now than in 2007.

Continuing on this theme, LCD tweeted this chart that contends that debt/EBITDA ratios of companies in the leveraged finance market are creeping up to 2008 levels. 

So what does this mean for the health of the highly leveraged companies? Does easy financing and higher debt load necessarily mean that we're going to see higher defaults in the future? 

On an aggregate, yes, we should see higher defaults when rates rise. But when it comes to investing, there are those firms that use leverage well, and there are those firms who use it frivolously. I firmly believe in the corporate finance theory of having debt as a way to reduce mismanagement of capital, assuming that managers are accountable for servicing the debt.  

If the debt is used for organic growth via research or capital expenditures, then the extra flexibility that comes with cov-lite loans and low rates may be a way for companies to "fake it 'till they make it", emphasis being on "make it". As a lender, I'd want to see not only free cash flow metrics and ability to service debt, but also reduction of superfluous costs, a strong market strategy, and investment in top-line growth. 

Bank of America Merrill Lynch's High Yield Strategist Michael Contopoulos recently published a report on cap-ex and M&A spending. Here's more:

"Although leverage has increased since the financial crisis, high yield companies today have the highest interest coverage ratios since the beginning of our dataset (1998) and overall leverage is well below the early part of the decade. Additionally, gross margins remain well above pre-crisis levels as the increase in COGS since the financial crisis has been matched by revenue growth...

In absolute terms, capex increased on a yoy basis between 2010 and 2012 as cash balances were drawn down and debt loads increased. High yield CEOs funded capex despite low revenue, using debt as the main financing tool to achieve organic growth. It seems to us, however, that with little return on their investment, we may be seeing a shift in sentiment, as capex spending has decreased and more cash is being layered onto the balance sheet. This is a bad sign for future in-house investment, but we think is a very bullish sign for M&A. CEOs are likely shifting strategies after realizing 2 years of capex funding has done little to improve revenue, and as such, will seek other strategies, namely acquisitions, to increase earnings." BAML

He included the following graphs below to show that high yield companies have more cash on their balance sheets than in 2007, but they aren't using it to for cap-ex just yet.

So are these companies amending and pretending or faking it for the time being? I am less optimistic about cash balances and debt being used for acquisitions than for cap-ex because transaction and integration costs could easily put a strain on liquidity. High interest coverage is fleeting if you acquire a company with lower EBITDA and spend too much cash on the acquisition. 

For companies that haven't made much progress internally to have leaner cost structures and organic growth, I think they're amending and pretending with the extension of terms. For companies who have cleaned up their cost structures and are awaiting the fruits of internal investments, I think they'll come out stronger with help of the easy financing, even when rates rise. 

Sick Hospitals

With all of the changes in the American healthcare industry, there are bound to be some casualties (pun intended). Becker's, which is my favorite resource for everything healthcare related, had an article yesterday listing the seven acute-care hospitals and health systems that have filed for bankruptcy protection or announced their closure in the first quarter of 2014. You can read the full article here.

Becker's also uses the MedPAC report to outline some of the signs of a beleaguered hospital, which includes qualitative and quantitative measures, such as low occupancy rate and a high readmission rate.

So what can be done for the troubled hospitals? The first step obviously has to be operational and financial restructuring. Working alongside lenders and banks, the hospitals can come up with terms that are manageable to the debtor and acceptable to the creditor.

Operational improvement can come from many different areas. Proper management of working capital can unlock a great deal of value. A good billing company may be able to save money by filing claims properly to expedite reimbursements from insurance companies. Moreover, it can be helpful to forecast scenarios with various levels of reimbursement rates to come up with a payables strategy. If there is a way to match payables timing with reimbursement timing, that would be ideal. Working with vendors and maybe even consolidating them or using intermediaries can go a long way in managing payables.

M&A is also a good way of keeping health systems alive since a larger entity can have more leverage with the payers, vendors and staff. Here's more:

"Although Mr. Beith (of Crain Brothers & Company) says the number of healthcare organizations that fit the profile of troubled hospitals that face an "inevitable transaction" has declined as more consolidation occurs, the market is still "fairly robust" for smaller hospitals with big financial problems. He says more aggressive buyers such as Ontario, Calif.-based Prime Healthcare Services are still willing to take on troubled facilities.

"We still see a reasonable three- to five-year runway of significant merger and acquisition activity," Mr. Beith says. "We'll continue to see financially stressed hospitals pursue transactions."

Michael Lane, a managing director with Hammond Hanlon Camp, predicts troubled hospital sales will actually pick up as merger and acquisition activity in general continues at a rapid pace and more independent hospitals realize they can't survive on their own.

Additionally, he says he has observed some of the "big guys" in the hospital industry still see strategic value in acquiring a struggling facility that they can rehabilitate with the right management, expertise and oversight. 'There are some strategic opportunities the smart acquirers don't shy away from, as larger health systems look to grow in size and expand their market areas,' he says." Becker's

Lastly, filing for bankruptcy, especially a pre-pack, may be desirable as well since selling assets in a 363 transaction can bring more buyers. 

"Hospitals may choose to employ this strategy of filing for bankruptcy as part of the transaction process when they have few alternatives, according to Mr. Beith. 'The basic financial implication of that is they are significantly upside down in terms of value versus their total outstanding indebtedness,' he says. 'Cleaning them up, so to speak, through bankruptcy process is an appropriate way for an acquisition to occur.'

Mr. Shields says identifying a partner before filing gives healthcare providers "a little bit of security" going into bankruptcy, although the strategy does have risk. 'They have a clear idea going into bankruptcy court that there will be someone on the other side to operate the hospital and take control of their assets,' he says. 'But there's risk in that. Once you go into bankruptcy, all bets are off. There's no guarantee that the bankruptcy judge is going to agree with your plans or that the partner will be there on the other side.' " Becker's

Sure there are risks associated with filing bankruptcy, but having a plan before going in seems absolutely essential in order to save the operation, jobs and ultimately lives of patients. 

For more on healthcare insolvencies, check out this podcast on the ABI website. It is from 2012, but many of the issues are still germane.