EOP deals conventional wisdom a blow

Blackstone's purchase of Equity Office Properties (EOP) is getting a lot of attention from bond traders for various reasons. First, we had all assumed that REITs were relatively LBO-proof. This is because REITs are generally highly levered to begin with, so piling more leverage on top was thought to be unfeasible in most cases. It is also because most REITs live with fairly restrictive bond covenants. So if a private equity firm wants to buy up a REIT, it isn't easy to do it with debt.

However, the financiers are proving smarter than the lawyers in finding ways around the covenants. Rumors are abound on how Blackstone will handle EOP's covenant debt. They always have the option of doing make-whole calls, but the make whole will be mucho expensive. EOP's 30-year debt has a make-whole call at +30bps to the old 30yr. That would mean those bonds would cost about $1.4 on the dollar to call via a make whole.

They would more likely tender bonds. I.e., Blackstone would publicly offer to buy bonds at some price from existing bond holders. The problem with that is bond holders know that Blackstone is forced to retire debt, therefore there is an incentive for bond holders to not sell. Usually in these cases, the tendering firm (Blackstone) will attempt to have the problematic covenants simply dropped. I'm hearing that EOP's debt is governed by simple majority, which would mean that if Blackstone can convince a majority of bond holders to drop the covenant, there ceases to be a covenant issue and the outstanding bonds can remain outstanding. They don't use charisma to do this, they use cash.

Here is how it might work. Take the 30-year bonds I mentioned earlier which have a make whole call worth $140. Blackstone tells bond holders they will buy bonds at $120 if the holder also agrees to vote to drop the covenant. This creates a sort of prisoner's dilemma. If a bond holder refuses the tender, they might get $140. But if a majority of bond holders accept the tender, the bonds go back to being worth par. Actually, less than par, since the new company would be more highly levered and undoubtedly be rated below investment grade.

Another option for Blackstone would be to "ring fence" certain bonds. This would involve creating a subsidiary with exactly enough assets to meet covenant requirements and assign the most expensive make-whole call bonds to that sub.

So these bond games will be fun to watch if you are an innocent bystander. If you are a cash bond holder, its probably going to be a profitable venture. If you are a CDS holder, the situation is a bit more murky. No default event has occurred, so nominally nothing has changed for the CDS holder, but at the end of all this, what deliverable securities will remain? Let's say that 3/4 of all bonds are tendered and all covenants are dropped, but 1/4 of bonds remain outstanding because they are stuck in some structure. Now those bonds are downgraded to junk, and for CDS holders, those becomes your reference bonds. So whole cash holders win, CDS holders lose.

Another harrowing part of all this is the realization that no one is safe from a buyout. If a highly levered REIT with restrictive bond covenants can command an 8% premium in a buyout, who knows what's next?