Wednesday, August 30, 2006

Only a penitent firm will pass...

Yesterday's journal included an article on hedge funds invoking rarely used covenants to force companies to pay off all their debt. I wrote about the issue of covenants a while ago here. Basically I said they were used as a means to force companies into paying concessions and less as a means of protecting the credit worthiness of the borrower. I may have been simplistic in my reasoning, but I stand by the idea. The story in the Journal reiterates the point I was trying to make.

Let's say you are ABC hedge fund and you have debt of UNH. The covenants allow you to force the company to repay all debt if the company does not report financials on time. The company is indeed late on reporting, and you go ahead and declare them in technical default. The way the story writes it, UNH would be forced to repay ALL of their 5.8% 2036 issue which was just issued in March at +119. The market for this issue now is 118/113, so that gives the bonds a 4 point discount at the moment. If UNH were forced to repay this issue, ABC hedge fund would make a quick 4%.

Now let's say for the sake of argument, that UNH was unable to issue new bonds. We know they don't have $850 million in cash, so forcing the technical default could cause an actual default. Would this serve the interests of ABC hedge fund? Of course not. They wanted to make the quick 4%. So what would the hedge funds do? They'd simply negotiate some payout with UNH and move on.

The article also mentions VTSS, which is a stock I once lost a boatload on. Anyway, VTSS faces the very real possibility of being forced into chapter 11 as a result of a technical default. In that case, the hedge funds apparently want to take control of the company and force a sale.

Is there a problem with all this? Heck no. Companies should face a penalty for not being able to report on time. If you are UNH, it may cost you a couple million to make the problem go away. If you are VTSS, it may spell the end. I have a hard time feeling sorry for either company.

Funny quotes from the story:

"There used to be a kind of brotherhood of bond investors, where you didn't want to be the guy who turned the kid in to the teacher because he wasn't wearing a shirt with a collar," said Kirk Davenport, a partner at law firm Latham & Watkins in New York. But now, it is "outweighed by the desire to make a lot of money."

Yeah Kirk, things were much better when the investment business was run by a bunch of white guys drinking martinis and watching out for each other. I hear Japan continued that tradition for a while after we gave it up. Dunno how well that worked out.

Andrew Redleaf is chief executive at Whitebox Advisors LLC, a $1.6 billion group of hedge funds that use the technical-default tactic. "Bondholders used to be extremely lazy," says Mr. Redleaf, whose firm holds bonds for both UnitedHealth and BearingPoint Inc., a consulting firm that also missed its filing deadline. "Part and parcel of what investors do is assert their rights, whether they're shareholders, bondholders or otherwise."

A lot of bond holders still are pretty lazy.

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