Bond Funds after a Spinoff: Take into Account the Covenants

During the past ten years, nearly 1,000 businesses with a combined worth of over $1.3 trillion have been spun out from their parent company. Businesses use spinoffs for several reasons, and although the most frequent justification is to “unlock shareholder value,” there are other methods to achieve that objective. Because various companies are valued differently by the market, certain assets may be divided up, and capital structures can be adjusted such that the individual pieces of a firm can fetch a total value higher than if they were kept together.

While firms in their development phases may need the additional flexibility that bearing less debt gives, stable, established organizations can frequently handle debt levels that are substantially greater. To concentrate on a particular area of the market or line of business, a company may spin off an entity. On the other hand, a corporation can think that allowing one or more split-off enterprises to seek diversification prospects will improve value. The new spinoff stock might pay for further acquisitions, expanded market reach, scaled-up economies of scale, or employee and management incentives. An independent corporation may draw in more outside cash. The spin might also be used to get rid of failing companies.

Current management or outside stakeholders, particularly activist investors, maybe the driving force behind the spin. It is imperative that fixed-income investors complete the requisite analysis since, regardless of their intentions, spinoffs can have a significant impact on the performance of the related corporate bonds. In particular, the covenants regulating each security are substantial. These covenants dictate whether the existing bonds must be redeemed, receive a permission payment to allow the spin, or stay outstanding.

Investment-grade credit spinoffs are relatively simple in terms of covenants. The conventional spinoff would not be prohibited by the usual set of investment grade covenants, which include a negative pledge, a restriction on sale or leaseback, and a change of ownership. Nonetheless, spinoffs for bonds subject to high-yield covenants often need to adhere to the payment limitation and asset sale limitation requirements. Since a spinoff is usually organized this way and the limited payment covenant limits dividends, it will only be allowed if it passes the restricted payments test.

The amount of an allowed payment is ordinarily equal to a builder basket, which typically increases by 50% of combined net income on a quarterly basis. There is frequently a separate carve-out for a specified maximum amount. If the spin-value off’s exceeds both of these limits, it will be illegal. If not allowed, the corporation would have to ask investors for covenant relaxation or redeem the bonds in order to continue through with the spin. Similarly, a spinoff is regarded as an auction process and must also meet this covenant.

The asset sale covenant often requires that the transaction be done at the actual market value, that a significant percentage of the proceeds be here in cash, and that the funds be applied to either retire specific senior debt at par or to buy replacement assets within a particular period. Yet, the limited payments covenant frequently allows for a carve-out for asset transactions in the form of little payments. In this situation, both covenants would permit the spinoff.

Such covenant characteristics and how important it is that bondholders comprehend them in the case of a spinoff are demonstrated by three spinoffs over the past ten years.
Hewlett-Packard Co.

In October 2014, Hewlett Packard (HPQ, rated Baa1/BBB+/A- at the moment) declared its plan to split into two businesses. Hewlett Packard Enterprise (HPE) would be the company’s enterprise technologies, software, and services division, while HP Inc. would be its personal system and printing division (HPQ).

At the time, the business was in the middle of a multi-year turnaround effort to overcome intense rivalry in its hardware industries and stop declining revenue. Providing each new business with the autonomy, focus, financial means, and flexibility they require to swiftly adjust to market and consumer dynamics while delivering long-term value for shareholders was the firm’s stated goal. Moreover, Hewlett Packard asserted:

Investors will have the chance to participate in two firms with compelling and distinctive financial profiles ideally suited to their operations due to the division into independent publicly listed companies, providing each company with its own highly focused equity currency.

Before its spinoff, the corporation had around $17 billion in lengthy debt, mostly in unsecured notes. Moreover, Moody’s, S&P, and Fitch all placed the firm’s credit ratings on the negative watch even though the business had said at the time that it anticipated both firms to maintain investment-grade ratings.

Initally, the company’s baseline 4.65s of 9 December 2021 expanded by about 30 bps. Eventually, Moody’s and S&P only downgraded HPQ’s investment-grade ratings by one rung, to Baa2/BBB. In September 2015, the new HPE stated its plan to payout the proceeds up to HPQ in preparation to tender for up to $8.8 billion of current HPQ near-maturity notes at the same time as it issued around $15 billion in bonds over 10 tranches. Instead of covenant concerns, the right-sizing of the capital structure was the driving force behind this offer, which was made before the spin was completed.

It was anticipated that HPE could handle greater debt than the narrower, more secularly challenging PC/printer business since it was a larger recurring income firm. As a result of these transactions, HPE would have debt totaling $16 billion, leveraged two times, on about $8 billion in LTM-adjusted EBITDA. In comparison, HPQ would have debt totaling $7 billion, leveraged less than 1.5 times, on approximately $5 billion in EBITDA. On the shorter end of the curve in this instance, the spin was positive. All maturities thru 2018 were either called or offered for at prices well over par, invoking the “make whole” clause. But, the lengthier maturities could have been more successful.

In October, the 2022s trading at a range of 230 basis points, but by year’s end, it had increased to almost 300 bps. The 2041s’ spread decreased from 325 bps in October to over 500 bps.

National Penn

The first-ever REIT comprising gaming assets was created when regional casino and racecourse operator Penn National (PENN) declared in November 2012 that it would spin off its real estate holdings from its gaming activities into a REIT. PENN anticipated the market could value the two components at a combined value more prominent than the current corporation since REITs sold — and continue to trade — at a considerably higher multiple than that of the gaming industry. While triple net lease REITs were selling at around 13x, the company was trading at 7x EV/EBITDA.
In addition to an estimated $1.8 billion secured debt credit facility, the corporation also had outstanding senior subordinated notes totaling $325 million at that time. These notes were rated B1/BB- when they were issued in August 2009, and as a result, they included the typical high-yield restrictions that included restrictions on restricted payments. Likewise, a spinoff must abide by the restricted payout covenant since it essentially serves as an equity dividend to the company’s owners.

In the instance of PENN, the corporation had to meet a builder basket requirement of either $100 million or 50% of its consolidated net income. Moreover, PENN had to distribute the whole amount of revenues and profits accrued during the years the firm was taxed as a standard C corporation in order to be eligible for REIT classification. It amounted to an extra $1.4 billion. As the bonds were not yet callable and this payment would obviously exceed what was permitted by the restricted payment covenant, PENN was required to redeem the bonds at the “make whole” or optional redeeming price of T+50, or $110.10.

The 8.75s were selling as yield to demand paper when the original spin announcement was issued. The securities were trading substantially above that price, at over $112, on the first call date of 15 August 2014, which was set at the cost of 104.375. As the bonds was called at $110, the transaction did not result in any further performance; nonetheless, the covenants offered important protection against PENN burdening the operating business with additional debt in connection with the spinoff. In reality, a B1/B+ rating was given to the new bonds following the spin.

Systems for Community Health

Acute care hospital owner and operator Community Health Services (CYH) stated in August 2015 that it planned to spin off 38 of these facilities together with its hospital administration and consulting company. Quorum Health (QHR), the new business, would concentrate on areas with populations of 50,000 or fewer. The transaction’s declared goals were to provide CYH the freedom to pursue expansion and acquisitions in bigger, more lucrative areas and to give both firms independent management teams and finance structures that were more following their goals. Also, CYH needed help with the properties it bought in the 2014 Health Management Associates transaction, which had somewhat lower operational outcomes.

Around $7.2 billion in secured credit facilities, $2.6 billion in senior secured notes, and $9.2 billion in senior unsecured notes were all outstanding at the time CYH made the statement. The senior secured bonds were rated BB by S&P on 8 August 2016 and Ba2 by Moody’s on 23 May 2016, both of which were reduced to Ba3 on that date. The senior unsecured notes were rated B3 by Moody’s before being reduced to Caa1 on 23 May 2016, while they were rated B- by S&P before being lowered to CCC+ on 8 August 2016.

With a $880 million senior secured term loan, a $100 million senior secured term revolver line of credit, and $400 million in senior notes, QHR entered the market in April 2016. In order to meet the asset sale covenant related to this facility, CYH used the $1.2 billion one-time special dividend from these offers to pay down secured bank loan debt. Significantly, the restricted payment wording of both notes permitted spinoffs; thus, the corporation wasn’t required to put down any secured or unsecured bonds.

Spreads widened when the market processed the information that the bonds might stay outstanding. Its senior secured spread over Treasury bonds was roughly 315 bps when the spinoff was announced initially. The margin had increased to almost 400 bps by the time the downgrades started in May. Similarly, before the spin, the unsecured trading at roughly +385 bps, and the spread increased to almost 800 bps.

Aware of the Covenants

Corporate bonds can perform quite differently after a spinoff, based on whether they remain with the original business or move with the new one, how much overall debt the new firms have, and most significantly, whether or not the bonds include covenants that safeguard investors. As there were no such covenants in the instance of investment-grade HPQ securities, the near-maturity bonds that were already in existence performed better than the bonds with later maturities. With PENN, the corporation was compelled to redeem the bonds at a premium by the bondholders due to the company’s strict high-yield covenants. In the instance of CYH, the business purposefully deleted protective wording from the covenants to the prejudice of bondholders, despite the fact it had been rated below investment grade.

So what should we conclude? Bondholders need to be aware of these covenants because they may significantly impact the final results following a spinoff.