EnvisionCap.com: Forbes Article

Takeover Insulation

Marilyn Cohen, Forbes Magazine, 09.17.07

ONE REASON FOR WALL STREET'S FRENZY: EPISODES of fear that credit will dry up and the leveraged buyouts that have energized the market will come to an end. The buyout game hinges on cheap, tax deductible borrowings. No Leverage, no buyouts. The LBO bunch normally has an appetite for debt that would shame a Sumo wrestler.

Well, the deal era is hardly over. Private equity financers will find some way to get the capital they need. Deals, which generate the fat fees they so enjoy, are their oxygen. They’re sitting on tens of billions of uninvested client dollars. I’ve never heard of a case where they returned the money to the customers.

And if they do hesitate, watch strategic buyers step in. That’s the Wall Street jargon for companies that buy other companies without any intention of flipping them. Corporate America still has lots of cash; the aftertax return on this cash is low compared with the earnings yield on purchased business; and there are lots of strategic reasons to combine, like getting economies of scale (witness Whole Foods and Wild Oats).

Leverage buying is good news for shareholders but bad news for bondholders. Maximizing shareholder value often minimizes bondholder value. If you own a corporate bond that doesn’t have covenant protection against your company’s being purchased, whether by a private equity or a strategic buyer, the purchase is likely to pile on a mountain of debt, which reduces your interest coverage and the possibility of repayment.

It’s quite possible for a strong business operation to be weak financially, if it’s buried under an avalanche of debt. That’s what happened to Spanish-language media empire Univision and hotel-casino operator Harrah’s Entertainment, to name just two. The bond buyer’s nightmare is waking up one morning to buyout news and seeing his nice A-rated corporate bond turned instantly to junk.

The way to protect yourself is to query your broker before you buy. Ask if the corporate bond has a “change of control” provision. This bond clause allows you to sell back your bond to the issuer, usually at a price of $1.01 on the dollar, in the event of a merger or corporate takeover.

A year ago Harrah’s bonds were investment grade (BBB- rating) and stood a good chance of being upgraded. Then last September LBO firm Apollo Management said it would buy the company. My client accounts held Harrah’s bonds, specifically the Harrah’s Entertainment 5.375% due Dec. 15, 2013. Right after the Apollo news they dropped 10% in value. You guessed it: They had no put option for a change of control.

Contrast what happened at Equity Office Properties after the Blackstone Group announced its purchase of the real estate investment trust last November. All of the bonds my clients held were redeemed. That’s because Equity Office, like most REITs, sold its bonds with strong protections for bondholders. Issuers don’t make these promises out of generosity. They make them to keep their interest costs down.

What should investors do? Look at the fine print. Here are some bonds I like, all with change of control protection.

Xerox has a $1.1 billion 5.5% issue due May 15, 2012, priced at $987 per $1,000 to yield 5.82% to maturity. These bonds, which once carried an A rating, plunged to a BB- junk status by 2002. Too much debt, too many management missteps and fearsome competition sank credit quality. Slowly and methodically new management rebuilt the business, causing a rebound in the share price and a return to investment grade for the bonds (now rated BBB-). Perhaps Xerox has recovered so smartly that a strategic buyer might find it a perfect fit. As Equity Office did, Xerox would make you whole at $1,010 per bond

The Costco Wholesale 5.3% due Mar. 15, 2012, a $900 million issue rated by Standard & Poor’s, are priced at 100.5. Should Costco look appetizing to an acquirer, the bonds will pay off at $1,010 per $1,000.

Janus Capital Group, the mutual fund company, has a $300 million issue of bonds: the Janus 6.25%, due June 15, 2012 and rated BBB-. They are priced at $101 for a 6% yield to maturity. The change-of-control premium is the standard 1%. These bonds also have another protective feature, which steps up the coupon if the bond rating sinks below investment grade. The coupon increases by a quarter of a percentage point for each rating-downgrade notch below BBB-. The company is doing well now, but it was in considerable turmoil during the tech crash at the turn of the century. The step-up is a nice feature to have.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.