First Data LBO

KKR has agreed to buy First Data Corp for $25.6 billion, which may or may not be the 2nd largest LBO ever. Depends on how you calculate such things. I don't know who gives a damn other than journalists anyway.

S&P cut First Data's bond rating to BB+ from A on the news. Pretty harsh. However their bonds have tightened dramatically on the widespread belief that the bonds will be tendered. Their 4.95% due in 2015 was 130/120 on Friday, now somewhere in the 80's. The bonds have a 20bps make whole call.

First Data has a non-subordination covenant in their debt. This means that they cannot pledge assets to support the credit of new bonds without similarly securing existing debt. I've mentioned this covenant before, as Alltel has the same restriction.

Here is why this is important. First of all, let's say you are a bond holder for ABC corp. Your bond is ABC corp's only piece of debt. ABC has a large factory, owns several warehouses, and owns the land under each. In the event ABC goes bankrupt, all of these things have value and can be liquidated in bankruptcy court. The proceeds of the liquidation would go to senior bond holders.

Now some enterprising investment banker comes to ABC and tells them that they can issue new bonds secured directly by their hard assets, get a very attractive rate, and use the proceeds to buy back stock. The old bond holders get completely screwed. Not only has ABC greatly increased their leverage, but now those nice assets you thought you could liquidate in bankruptcy will instead go to the new bond holders first. In essence, you've just become a subordinated creditor!

Ford recently did just this. They were unable to get a extension of their credit lines without securing the lines with hard assets. Existing creditors became de facto subordinated to the banks offering credit lines.

Now let's turn to the subject of LBO's. Typically an LBO results in a large enough increase in leverage to merit a junk rating. Witness FDC's new rating. But all that new leverage doesn't come from thin air, the firm has to either issue bonds or take out bank loans. For a BB-rated firm, the cost of issuing unsecured bonds may be intolerably high. And banks will likely insist on some level of securitization. Unfortunately, there may not be enough assets to secure all bonds equally and at the same time satisfy lenders.

So the post-LBO company may want to take out bank loans which are secured then issue bonds which are unsecured. But they can't do this without getting rid of the non-subordination covenant. This is accomplished through a consent tender. Basically the company offers to buy the bonds from existing holders at a large premium (usually at or near the make-whole level). Any holder that agrees to the tender, also agrees to eliminate the covenant. Most bond holders will be happy to sell their bonds and don't give a damn what happens to the covenants after they've sold their holding. If enough holders consent (sometimes just a majority, sometimes a super majority), then the covenant ceases to exist.

Notice this is marginally cheaper than just doing a make-whole call. First, you might get bond holders to agree to a price slightly lower than the make-whole level. That depends on how well organized the holders are. Second, some bonds will be tied up in non-tradable situations, like a CBO. These holders won't tender, but would have automatically participated in a make-whole call. Plus some holders might not tender because they are brain dead. Never underestimate the degree of brain deadedness in the bond world.

Any bonds not tendered will get murdered. Because not only have the bonds been downgraded severely, they've also been subordinated by the new secured debt. Also, these old bonds are often the only reference obligations remaining for CDS holders. So CDS holders get murdered also.

Note that the CDS becomes a poor hedge for the cash bonds in this case. Say a dealer desk got short a cash bond in FDC to fill a client offer wanted. The trader also shorted protection in the CDS to hedge his short cash position. Now the CDS is wider and the cash bonds are tighter both by wide margins.

Aren't bonds fun?