Corporate finance: Debt
We will discuss the economics and legal aspects of debt financing: leverage, characteristics as well as key contractual terms.
1. Leverage and Debt
Leverage is the financial impact on a company when it borrows money. In fact “debt” and “leverage” are used interchangeably by those operating in finance. Leverage is using given resources in such a way that the potential positive (gains) or negative outcome (losses) is magnified on a company’s common stock. The leverage effect occurs for two reasons:
a lender of capital (bank, bondholder) has a fixed contractual claim on a corporate borrower. The claim is limited to the payment of interest and the repayment of principal according to the contract evidencing the debt. The return to the lender is capped at the rate of interest.
the return that a company earns on its use of borrowed funds in not limited. It may be more, less or equal to the rate of interest associated with the debt. Stockholders have a residual claim to the monies left after the lender’s claim is satisfied, so any return on borrowed funds that exceeds the cost of those funds accrue solely to the stockholders.
For example: ACME pursues a project that requires a $100 million investment. The company expects to earn $14 million per year from this project, a return on investment (ROI) of 14%. ACME invests $50 million using the proceeds from the sale of common stock. It finances the balance with funds borrowed from a commercial bank at a rate of interest of 12% p.a., thus requiring ACME to make an annual interest payment of $ 6 million (transaction costs, allowances and tax effects are ignored in this example).
Leveraging the investment will increase ACME’s pre-tax cash flow more than if it had financed the investment solely from equity sale.
ROE = (investment return (ROI) – interest payment) / equity
ROE = ( 14 – 6 ) / 50 = 16%
This result compares favorably to the 14% return on equity achieved when ACME uses 100% equity to finance the same project.
ROE = ( 14 – 0 ) / 100 = 14%
ACME must receive an annual investment return from the project of at least 12% for the leverage to benefit the company. This is the break-even point where there is no gain or loss from the use of leverage. If the project were to earn only 10%, the ROE would fall to 8% because the project is earning less than the cost of borrowed funds.
In this example, the debt to equity ratio is 1:1 (debt financing: $ 50 million / equity financing: $50 million).
If ACME would consider 4 projects requiring $400 million investment with a ROI of 10%, to be financed by $100 million of equity capital (sale of common stock) and $300 million borrowing from a commercial bank, at an annual interest rate of 6%, the net expected return per year will be $22 million and the ROE = ( $40 million – $18 million) / $100 million of equity financing or 22%. In this case the debt-to-equity ratio is 3:1 (debt financing: $300 million / equity financing: $ 100 million).
In theory, ACME could borrow all the money for as many projects as available, thus maximizing the leverage effect. In reality, this is not possible because of the default risk associated with such substantial leverage, as the future cash flows associated with the projects may not materialize. Lenders are well aware of this.
As a company debt-to-equity ratio increases, so does its default risk; and its ability to service its debt obligations decreases. “Best case scenario” on which highly leveraged companies depend can become a risky proposition.
Debt-to-equity ratio, which varies from industry to industry, ROE, which is the stockholder’s rate of return, and default risk are the factors to consider for the use of leverage in financing investment opportunities.
2. Characteristics of a debt
2.1 Instruments
The following three instruments represent contractual claims against the corporate borrower, evidenced by a promissory note, which incorporates the terms of a contract typically called indenture: particularly the amount borrowed, the maturity date and the interest to be paid until maturity.An indenture is a contract between the issuer of the debt securities and the indenture trustee, typically a commercial bank, that acts as the agent for the actual holders of the debt securites and serves to protect their rights.
Bond: long-term promissory (10 to 30 years) notes with long term maturity, secured by collateral of the corporate issuer. The denomination is known as the bond’s face value or par value, which the issuer must repay to the investor on maturity date. The rate of interest is referred to as the coupon rate. Terms of a particular issuance of bonds are set forth in a contract, the bond indenture. The signatories of this contract are the issuer and the indenture trustee. Technically, the bond-holders are third-party beneficiaries of that contract.
Debenture: long-term (10 to 30 years), unsecured promissory note. The debenture indenture is similar to the bond indenture.
Note: short-term ( 5 to 10 years) promissory note, maybe either secured or unsecured obligations of the corporate issuer. The terms of the contract are set forth in the note agreement. The note holder is often a direct and private signatory to the note agreement.
2.2 Debt security rating services
Moody’s Investors services and Standard and Poor’s Corp. are currently the two primary rating services. They assess the likelihood that an issuer (corporation or government) will meet its debt service obligations. Debt ratings are not permanent. When the rating agencies disagree on the rating of a debt security, it is said to have a “split rating”.
3. Key contractual terms and protective provisions
3.1 Promise to pay
The issuer’s promise to repay debt holders the borrowed funds along with interest is fully enforceable in contract by the debt holders, as it was given by the issuer in a bargained for exchange in return for the loaned funds. Besides relying on the issuer’s naked promise to repay its debt, many investors insist on additional indenture provisions designed to reduce the risk or impact of a payment default.
One way to reduce the risk of non-payment is to “collateralize” the debt securities. If the issuer defaults, and the default is not cured in a timely fashion, the debt holders can seize, through the indenture trustee, the collateral supporting the issuer’s payment obligation (including land, accounts receivable, inventory and equipment), sell it and pay themselves back with the proceeds.
Another way is to demand a guarantee from a third party. Guarantee may take many forms: payment guarantee, whereby the guarantor must pay if the issuer does not, or equity infusion guarantee, whereby a third party commits to infusing equity capital if the debt-to-equity ratio becomes dangerously unbalanced.
Parties closely affiliated with issuers generally provide guarantees, because of the indirect benefits they receive when the issuers gain access to the loaned funds: i.e. controlling stockholder, holding company.
A third way is through the creation of a sinking fund. A sinking fund indenture provision requires the issuer to periodically deposit funds or cash flow into a custodial account maintained by the indenture trustee. The issuer will then have the funds necessary to repay the principal when the securities mature. On the negative side, the issuer cannot use those funds to grow its business.
3.2 Subordination
When an issuer has several classes of debt securities outstanding (i.e. bonds and debentures) the priority in which debt holders of different classes are repaid is crucial and is particularly important in case of bankruptcy or liquidation. The concept of subordination refers to holders of senior debt securities ranked ahead of holders of the other two classes of subordinated debt securities and the ensuing ‘food chain’ effect.
Ranking of debt securities is purely a matter of contract law: the indenture must provide so. Subordination is a topic of negotiation. Investors in subordinated debt demand higher interest rates. Subordinated debt securities are referred to as high-yield debt securities and junk bonds or ‘equity in drag’.
3.3 Covenants
Covenants are designed to ensure that the issuer operates in a most conducive way to fulfilling its promise to repay the debt holders. A debt indenture contains two types of covenants:
Affirmative covenant: the issuer promises to perform specified, affirmative acts. I.e. maintain property and corporate existence, pay the taxes, deliver financial information to the indenture trustee, obtain and maintain insurance on the property. Most indentures contain standard affirmative covenants.
Negative or restrictive covenant: by opposition, the issuer promises not to engage in specified acts. “Thou shall not.”
Limitation on the incurrence of indebtedness:
To prevent the issuer from increasing its debt load unless it is generating enough cash flow to easily satisfy its principal and interest payments on the debt securities in question. Debt increases the issuer’s leverage, thus increasing the issuer’s default risk; additional debt increase the number of creditors competing for the issuer’s assets in the case of bankruptcy or liquidation; the increase in risk associated with the increase in debt securities often diminishes the value of the existing securities.
The covenant typically specifies the amount of additional indebtedness allowed to the issuer, and only if certain financial liquidity ratios are met.
Restricted payments:
To keep money within the issuer for use in servicing the debt obligations. The covenant prohibits the issuer from distributing cash dividends or repurchasing stocks; purchasing or redeeming any indebtedness of the issuer subordinated to the debt securities in question.
Assets sale:
To prohibit an issuer from selling substantial assets unless no default or event of default exists, the asset is valued at fair market price and a high percentage (90%) of the consideration received is cash or cash equivalent, the proceeds are reinvested in the core operations within a specified time frame.
Merger, consolidation
To prevent the issuer from consolidating, merging or selling all or substantially all of its assets unless certain conditions are met: the issuer must be a surviving entity; the surviving entity must assume all of the issuer’s obligations under the indenture; the valuation of the issuer after the transaction is not less than the issuer’s value prior to the transaction; immediately after the transaction no default or event of default must exist; the issuer or surviving entity must be permitted to incur additional indebtedness under the limitation of incurrence of indebtedness covenant.
This is to restrict the issuer to engage in a reorganization in which the issuer does not survive or becomes financially weaker.
Dividends and other payment restriction on subsidiaries
In the case where the issuer is a holding company, to prohibit the issuer and its subsidiaries from entering into contract and agreement that could impede the subsidiaries to up-stream cash to the holding company.
Transactions with affiliates
To prevent sweetheart deals between the issuer and his affiliates (controlling stockholder) which siphon off funds of the issuer that could be used to service the debt obligations.
Restrictions on liens
When the issuer has issued secured (collateralized) debt securities, to prohibit the issuer from permitting liens on its assets unless certain conditions are met. Permitted liens generally include: lines in favor of the issuer; liens on assets of companies that are merged with the issuer; liens to secure the performance of statutory obligations; liens securing the debt securities in question; liens securing additional indebtedness under the limitation of incurrence of indebtedness covenant; liens for taxes; liens pre-existing at the date of the debts securities in question.
Line of business
To prohibit the issuer from engaging in any business activity other than those specified in the indenture. As in “the devil you know is better than the one you don’t know”.
3.4 Redemption
The indenture may provide for optional and/or mandatory redemption of the securities prior to their maturity date. After the date the issuer determines for redemption, debt securities no longer earn interest and debt holders are only entitled to receive the redemption price from the issuer. Therefore, debt holders have an incentive to turn in their securities on or before the redemption date.
Optional redemption
The ability to pay off debt securities prior to their maturity is something most issuers seek, against which most investors fight. The market conditions at the time play an important role in the decision of each party.
Indentures ordinarily contain a compromise. The issuer receives the ability to redeem (call away) its debt securities early, but only after a period of years during which redemption is prohibited. This period is called “call protection”. Thereafter, the issuer has the option of redeeming some or all of the securities at a premium, plus accrued and unpaid interest (if any) to the date of redemption. The issuer cannot voluntarily trigger a default under the indenture in an attempt to avoid paying the redemption premium. Another call protection arises when an indenture allows for optional redemption, but specifies that debt securities cannot be redeemed with the proceeds from the issuer’s incurrence of new, lower interest rate debt.
Mandatory redemption
Many indentures require an issuer to redeem some or all of its debt securities prior to their maturity upon the incurrence of certain events: the cash flow from operations is greater than a predetermined benchmark, if the issuer has not redeployed excess proceeds from asset sales within the specified period of time in the asset sales covenant; in the case of a change of control (sale of the issuer’s assets, participation in the capital to 25-35%, change in the board of continuing directors) forcing a potential acquirer to either negotiate with the debt holders
3.5 Events of default
All indentures define events of default and specify the consequences of the occurrence of such events.
Default in the payment of interest or principal
Referred to as payment default, it is the most fundamental event of default. A grace period (30 days) may attach to a default on interest payment, but not on a principal payment. If the issuer misses a principal payment or fails to make an interest payment, then indenture trustee may declare the full principal amount plus any accrued and unpaid interest, immediately due and payable. This situation is known as the acceleration of the debt.
Breach of covenant, warranty or representation
An issuer’s breach of any of its covenants, warranties or representations qualifies as an event of default. If the issuer shows no inclination to cure, does not cure or refuses to engage in dialogue with the indenture trustee within the grace period, the indenture trustee may declare the full principal amount plus any accrued and unpaid interest, immediately due and payable.
Bankruptcy, insolvency
An involuntary order resulting in the issuer’s bankruptcy or insolvency, a voluntary filing of a bankruptcy petition by the issuer constitutes an event of default.
Cross-default
An indenture may contain a cross-default provision. Any default by the issuer under any other agreement evidencing indebtedness generally constitutes an event of default. If an issuer triggers the cross-default provision, the indenture trustee can take action even if those debts securities are not yet in default.
