A Pragmatist’s Guide to Leveraged Finance_ Credit Analysis for Bonds and Bank Debt

A Pragmatist’s Guide to Leveraged Finance Credit Analysis for Bonds and Bank Debt Robert S K richeff Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Operations Specialist: Jodi Kemper Senior Marketing Manager: Julie Phifer Assistant Marketing Manager: Megan Graue Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editor: Anne Goebel Copy Editor: Gayle Johnson Proofreader: Debbie Williams Senior Indexer: Cheryl Lenser Compositor: Nonie Ratcliff Manufacturing Buyer: Dan Uhrig © 2012 by Robert S Kricheff Publishing as FT Press Upper Saddle River, New Jersey 07458 T his bo o k is so ld w ith the understanding that neither the autho r no r the publisher is engaged in rendering legal, acco unting, o r o ther pro fessio nal services o r advice by publishing this bo o k E ach individual situatio n is unique T hus, if legal o r financial advice o r o ther expert assistance is required in a specific situatio n, the services o f a co mpetent pro fessio nal sho uld be so ught to ensure that the situatio n has been evaluated carefully and appro priately T he autho r and the publisher disclaim any liability, lo ss, o r risk resulting directly o r indirectly, fro m the use o r applicatio n o f any o f the co ntents o f this bo o k FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales For more information, please contact U.S Corporate and Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com For sales outside the U.S., please contact International Sales at international@pearson.com Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners All rights reserved No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher Printed in the United States of America First Printing March 2012 ISBN-10: 0-13-285523-2 ISBN-13: 978-0-13-285523-5 Pearson Education LTD Pearson Education Australia PTY, Limited Pearson Education Singapore, Pte Ltd Pearson Education Asia, Ltd Pearson Education Canada, Ltd Pearson Educatión de Mexico, S.A de C.V Pearson Education—Japan Pearson Education Malaysia, Pte Ltd Library of Congress Cataloging-in-Publication Data: Kricheff, Robert, 1963A pragmatist’s guide to leveraged finance : credit analysis for bonds and bank debt / Robert Kricheff 1st ed p cm ISBN 978-0-13-285523-5 (hardcover : alk paper) Financial leverage Securities I Title HG4521.K7375 2012 332.63’23 dc23 2011049988 I would like to dedicate this book, with love, to my wife and my parents, all of whom I am blessed to have Contents C hapter Intro ductio n C hapter C o mmo n Leveraged F inance T erms General Terms Yield and Spread Definitions Questions C hapter D efining the M ark et and the R atings Agencies C hapter T he Participants The Issuers The Sell Side The Buy Side Private Equity C hapter W hy Is Leveraged F inance Analysis U nique? C hapter T he M ajo r C o mpo nents o f Analysis The Components A Pragmatic Point on the Various Aspects of Analysis C hapter So me F eatures o f B ank Lo ans Questions C hapter A Primer o n Prices, Yields, and Spreads The Basics A Few Points on Yields A Few Points on Spreads Bank Loan Coupons Duration Total Returns Deferred Payment Bonds: Prices and Yields A Pragmatic Point on Terminology Questions C hapter A Primer o n Key Po ints o f F inancial Statement Analysis EBITDA Capital Expenditures Interest Expenses Taxes Changes in Working Capital Free Cash Flow The Balance Sheet A Pragmatic Point on Financial Statements Questions C hapter 10 C redit R atio s EBITDA/Interest Ratio Debt/EBITDA A Pragmatic Point on the Leverage Ratio A Pragmatic Point on Valuations Free Cash Flow Ratios Changes in Working Capital Dividends Acquisitions One-Time Charges The FCF/Debt Ratio A Pragmatic Point on Free Cash Flow Questions C hapter 11 B usiness T rend Analysis and O peratio nal R atio s Business Trends Margins and Expenses Capital Expenditures Questions C hapter 12 E xpectatio ns, M o deling, and Scenario s Sales and Revenue A Full Model Scenarios A Pragmatic Point on Bank Maintenance Covenants and Expectations Questions C hapter 13 Structural Issues: C o upo ns Loan Coupons Bond Coupons Zero and Zero-Step Coupons How the Coupon Is Determined Modeling Changes in Coupons Questions C hapter 14 Structural Issues: M aturities, C alls, and Puts Maturities Calls Clawback 10% Call Cash Flow Sweeps AHYDO Other Bank Prepayments Open-Market Repurchases A Pragmatic Point on Early Refinancing of Debt Questions C hapter 15 Structural Issues: R ank ing o f D ebt Ranking Structural Subordination Subsidiary Guarantees Questions C hapter 16 Key Leveraged F inance C o venants Debt Incurrence Defined Terms and Carve-outs Defined Term Examples Carve-outs Restricted Payments Change of Control Asset Sale Reporting Requirements Other Covenants Affirmative/Maintenance Covenants Restricted and Unrestricted Groups Questions C hapter 17 Amendments, W aivers, and C o nsents Questions C hapter 18 M ak ing M o ney o r Lo sing It O ff o f New s E vents Scenario: An Issuer Makes an Acquisition FastFoodCo (FFC) Facts GoodFoodCo (GFC) Facts Deal Facts Scenario: The Issuer Gets Bought Scenario: An Issuer Announces an IPO Scenario: An Issuer Is Facing a Maturity A Pragmatic Point on the Blended Price to Retire Debt Questions C hapter 19 M anagement and O w nership C hapter 20 I’m Lo o k ing at D ebt, So W hy D o es E quity M atter? Valuation Monitoring Equities Questions C hapter 21 Value, R elative Value, and C o mparable Analysis Questions C hapter 22 New Issuance C hapter 23 D istressed C redits, B ank ruptcy, and D istressed E xchanges Claims Classes of Claims Subordination Claims Arising from Bankruptcy Valuing the Enterprise Sale or Restructuring Restructuring Without Bankruptcy A Few Pragmatic Points on Bankruptcy Reorganizations Questions C hapter 24 Preparing a C redit Snapsho t C hapter 25 T he Investment D ecisio n Pro cess A Sample Investment Process Big-Picture Items The Company Credit Fundamentals Event Analysis Security Analysis Relative Value and Return The Decision Some Investment Traps C hapter 26 C lo sing C o mments Answ ers Index 10 amendments and waivers, 38 assignment versus participation, 38-39 calls, 126-129 cash flow sweeps, 131-132 clawbacks, 129-130 mandatory prepayments, 132-133 open-market repurchases, 133-134 10% calls, 130-131 coupon structures, 44-45, 113-114 defined, maturities, 125-126 new issuance analysis, 217-220 pricing and yields, 12-13 ranking of debt, 137-138 structural subordination, 141-144 subsidiary guarantees, 145-147 types of, 138-141 security of, 39 structure of, 36-38 types of, 35-36 co rpo rate bo nds See also leveraged finance calls, 126-129 10% calls, 130-131 AHYDO, 132 cash flow sweeps, 131-132 clawbacks, 129-130 mandatory prepayments, 132-133 open-market repurchases, 133-134 corporate bank loans versus, 36-38 coupon structures cash pay step coupon bonds, 119 pay-in-kind (PIK) notes, 119-120 purpose of deferred payment bonds, 121 toggle bonds, 120 types of, 115 zero coupon bonds, 115-118 zero-step coupon bonds, 118-119 deferred payment bonds, 46-48 defined, duration, 45 maturities, 125-126 new issuance analysis, 217-220 151 pricing and yields, 12-13, 41-43 ranking of debt, 137-138 structural subordination, 141-144 subsidiary guarantees, 145-147 types of, 138-141 refinancing, 134-135 relative value analysis, 209-215 stocks versus, tendering for, 135 co st o f go o ds so ld, 88 co upo ns See also interest rate for corporate bank loans, structures of, 113-114 for corporate bonds cash pay step coupon bonds, 119 pay-in-kind (PIK) notes, 119-120 purpose of deferred payment bonds, 121 toggle bonds, 120 types of, 115 zero coupon bonds, 115-118 zero-step coupon bonds, 118-119 determining, 121-122 floating-rate coupons, 44-45 modeling changes, 122-123 co venant default See technical default co venants, 149-151 See also affirmative co venants affirmative covenants in corporate bank loans, 38 defined, in forecasting, 110-111 types of, 163-164 asset sale, 160 carve-outs, 155-156 change-of-control covenants, 158-159, 185-186 changes to, 169-176 debt incurrence limit, 151-153 defined, defined terms, 152-155 miscellaneous restrictions, 162-163 permitted-investment covenant, 158 reporting requirements, 161-162 restricted and unrestricted groups, 165-166 152 restricted payments, 156-158 terminology, 163 credit, defined, credit analysis See leveraged finance analysis credit analysts, traits o f, 251-252 credit snapsho ts, preparing, 239-242 D D C F (disco unted cash flo w ) analysis, 77-78 debentures See co rpo rate bo nds debt See also leverage; maturity in balance sheet, 62-64 FCF/debt ratio, 82 in full model example, 99-108 ranking of, 137-138 structural subordination, 141-144 subsidiary guarantees, 145-147 types of, 138-141 refinancing, 134-135 restructuring, 223-224, 231-234 complex structures in, 236-237 without bankruptcy, 233-236 total debt, 154 debt incurrence limit, 151-153 debt/E B IT D A ratio , 72-77, 151 debt/equity ratio , 75 debto r-in-po ssessio n (D IP) lo ans, 229 decisio n-mak ing See investment decisio n pro cess default, defined, deferred payment bo nds, 46-48, 115 AHYDO, 132 cash pay step coupon bonds, 119 pay-in-kind (PIK) notes, 119-120 purpose of, 121 toggle bonds, 120 zero coupon bonds, 115-118 zero-step coupon bonds, 118-119 defined terms, 130, 152-155 depreciatio n o f capital expenditures, 57-58 D IP (debto r-in-po ssessio n) lo ans, 229 disco unt margin, 44 153 disco unt no tes, 46-48 disco unted cash flo w (D C F ) analysis, 77-78 distressed co mpanies bankruptcy analysis, 221-224 reasons for, 221-222 distressed investment funds, 24 dividends in free cash flo w ratio s, 80 “dro p aw ay” in co venants, 162 due date See maturity duratio n, defined, 45 E early debt retirement See calls E B IT D A, 52-57 adjusted EBITDA, 219 debt/EBITDA ratio, 72-77, 151 as defined term, 154-155 in equity valuations, 201-206 E B IT D A margins in business trend analysis, 88 E B IT D A/debt ratio , 77 E B IT D A/interest ratio , 69-72, 151-153 enterprise value (E V) in bankruptcy analysis, 230-231 total market enterprise value, 73 equity in debt rankings, 140 defined, monitoring equity markets, 206-207 reasons for analyzing, 201 super-voting power in common stock, 198 valuations, 201-206 equity analysis, leveraged finance analysis versus, 27-30 E V (enterprise value) in bankruptcy analysis, 230-231 total market enterprise value, 73 event scenario analysis, 33, 179-180 acquisition by issuer, 180-185 buyout of issuer, 185-189 debt maturity faced by issuer, 192-194 IPO announcement by issuer, 189-192 exchange o ffers, 174-176 154 expectatio ns See fo recasting expenses in business trend analysis, 88-90 in full model example, 99-108 extrapo latio n See fo recasting F face value See principal “fallen angels,” F C F See free cash flo w financial liquidity in leveraged finance analysis, 5, 32 financial repo rting requirements, 161-162 financial statement analysis, 51-52 balance sheet, 62-64 capital expenditures, 57-58 changes in working capital, 59-60 EBITDA, 52-57 free cash flow, 61 interest expenses, 58-59 statement of cash flows, importance of, 64-65 taxes, 59 fixed assets See capital expenditures fixed charge co verage ratio in debt incurrence limit, 151-153 fixed-rate co upo ns in co rpo rate bo nds, 115 flo at, defined, 203 flo ating-rate co upo ns in corporate bank loans, 36, 44-45, 113-114 in corporate bonds, 115 fo recasting, 95-96 full model example, 99-108 maintenance covenants in, 110-111 sales and revenue modeling, 96-98 scenarios, 108-109 free cash flo w , 61, 79-83 G go ing private in fo recasting, 96 grace perio d, defined, 9, 173 guarantees in debt rank ings, 145-147 H hard assets, 249 155 hedge funds, 24 hedges o n interest rate, 122 high yield mark et See leveraged finance hit, defined, 12 ho lding co mpanies, ro le in structural subo rdinatio n, 141-144 ho ldo uts, 235 I impaired classes in bank ruptcy claims, 226 “in the mo ney,” 202 inco me statement EBITDA derived from, 54 interest expenses in, 58-59 taxes in, 59 indenture, defined, individual bo nds, w ho le bo nd issue versus, 116-117 initial public o ffering (IPO ) anno uncement by issuer scenario , 189-192 interest expenses EBITDA/interest ratio, 69-72, 151-153 in financial statement analysis, 58-59 interest payments on corporate bonds and loans, 13 post-petition interest, 225 interest rate See also co upo ns corporate bank loan coupon structures, 44-45, 113-114 corporate bond coupon structures cash pay step coupon bonds, 119 pay-in-kind (PIK) notes, 119-120 purpose of deferred payment bonds, 121 toggle bonds, 120 types of, 115 zero coupon bonds, 115-118 zero-step coupon bonds, 118-119 defined, determining, 121-122 modeling changes, 122-123 investment bank s, ro le o f, 22-23 investment decisio n pro cess, 243-244 avoiding traps, 248-250 sample process, 244-248 investment grade analysis, leveraged finance analysis versus, 27-30 156 investment traps, avo iding, 248-250 IPO anno uncement by issuer scenario , 189-192 issuers defined, reasons for issuing debt, 21-22 J–L junk bo nd mark et See leveraged finance “lemming effect,” 250 leverage, defined, leverage ratio , 72-77 in debt incurrence limit, 151 in equity valuations, 201-206 leveraged finance companies in market, 2-3 definition of market for, 1-2 participants in, 21 buy side, 23-25 issuers, 21-22 private equity (PE) firms, 25-26 sell side, 22-23 terminology, 7-13 total returns, 45-46 volatility in, 27 leveraged finance analysis business trend analysis, 85-86 annual and quarterly comparisons, 86-87 capital expenditures, 91-92 margins and expenses, 88-90 components of, 5, 32-33 financial statement analysis, 51-52 balance sheet, 62-64 capital expenditures, 57-58 changes in working capital, 59-60 EBITDA, 52-57 free cash flow, 61 interest expenses, 58-59 statement of cash flows, importance of, 64-65 taxes, 59 investment decision process, 243-244 avoiding traps, 248-250 sample process, 244-248 157 investment grade analysis versus, 27-30 ratio analysis, 67-68 carve-outs, 155-156 debt/EBITDA ratio, 72-77, 151 discounted cash flow (DCF) analysis, 77-78 EBITDA/interest ratio, 69-72, 151-153 equity valuations, 201-206 free cash flow ratios, 79-82 traits of credit analysts, 251-252 unique aspects of, 4-5 liabilities See debt; leverage LIB O R (Lo ndo n Interbank O ffering R ate), defined, LIB O R flo o r, 45, 114 lift, defined, 12 lines-o f-business co venants, 162 liquidity free cash flow, 61 in leveraged finance analysis, 32 lo an bo o k , defined, lo ans See co rpo rate bank lo ans M macro drivers in sales and revenue mo deling, 96-97 M AD (mark et-adjusted debt)/E B IT D A ratio , 76 maintenance co venants See affirmative co venants management, analyzing ro le o f, 197-199 mandato ry prepayments o n co rpo rate bo nds and lo ans, 132-133 margins in business trend analysis, 88-90 mark et See leveraged finance mark et-adjusted debt (M AD )/E B IT D A ratio , 76 maturity of corporate bank loans and bonds, 125-126 debt maturity faced by issuer scenario, 192-194 defined, springing maturity, 164 mergers See acquisitio ns mo deling coupon changes, 122-123 full model example, 99-108 maintenance covenants in, 110-111 sales and revenue modeling, 96-98 158 mo ney terms, defined, 9, 170 mo nito ring equity mark ets, 206-207 M o o dy’s, catego ries o f ratings, 18 mutual funds, 24 N NC L (no ncall fo r life) bo nds, 129 negative co venants, defined, negative pledges, 145 new issuance analysis, 217-220 new s events See event scenario analysis no ncall fo r life (NC L) bo nds, 129 no ncash po rtio n o f o ne-time charges, 81 no nrated lo ans and bo nds, 19 no tes See co rpo rate bo nds “no tw ithstanding” in co venants, 163 O O IB D A, 53 O ID (o riginal issue disco unt), 225 o ne-time charges in free cash flo w ratio s, 81 o pen-mark et repurchases, 133-134 o perating leverage in business trend analysis, 88 defined, 72 o peratio nal co mparable analysis, 213-214 o peratio nal risk s, subjective facto rs in, 85-86 o peratio nal trend analysis See business trend analysis “o r” in co venants, 163 o riginal issue disco unt (O ID ), 225 “o ut o f the mo ney,” 202 o verfunding, 121 o w nership, analyzing ro le o f, 197-199 P par, defined, 10 par value See principal pari passu, defined, 10 participants in leveraged finance, 21 buy side, 23-25 issuers, 21-22 private equity (PE) firms, 25-26 159 sell side, 22-23 participatio n, assignment versus, 38-39 Patto n, G eo rge S., Jr.250 pay-in-k ind (PIK) no tes, 46-48, 119-120 PE (private equity) firms, 25-26, 187-188, 200 per-bo nd issue, w ho le bo nd issue versus, 116-117 permitted-investment co venant, 158 PIK (pay-in-k ind) no tes, 46-48, 119-120 po st-petitio n interest, 225 preferred sto ck in debt rank ings, 140 pre-pack aged bank ruptcy, 235-236 prepayments o n co rpo rate bo nds and lo ans, 132-133 pricing blended pricing, 193 for corporate bonds and loans, 12-13, 41-43 on deferred payment bonds, 46-48 duration, 45 ratings agencies’ impact on, 19 total returns, 45-46 pricing grid, 114 priming, 147 principal accreted value versus, 46-47 defined, 10 private, meaning in fo recasting, 96 private bank investo rs, public bank investo rs versus, 39 private equity (PE ) firms, 25-26, 187-188, 200 pro fo rma in business trend analysis, 87 defined, 10 pro rata, defined, 10 pro spectus, defined, 10 public bank investo rs, private bank investo rs versus, 39 put, defined, 10 Q–R qualified institutio nal buyers (Q IB s), 26 rank ing o f debt, 137-138 structural subordination, 141-144 subsidiary guarantees, 145-147 types of, 138-141 160 ratings agencies, 17-19 categories of ratings, 18 nonrated loans and bonds, 19 price impact of, 19 value of, 18-19 ratio analysis, 67-68 carve-outs, 155-156 debt/EBITDA ratio, 72-77, 151 discounted cash flow (DCF) analysis, 77-78 EBITDA/interest ratio, 69-72, 151-153 equity valuations, 201-206 free cash flow ratios, 79-82 refinancing corporate bonds, 134-135 debt maturity faced by issuer scenario, 192-194 relative value analysis, 209-215 relative value o f investment in leveraged finance analysis, 33 repo rting requirements co venants, 161-162 restricted gro ups, 165-166 restricted payments, 156-158 restructuring debt, 223-224, 231-234 complex structures in, 236-237 without bankruptcy, 233-236 return-o n-equity (R O E ) analysis, 91 return-o n-investment (R O I) analysis, 91 revenue mo deling, 96-98, 99-108 revo lvers, defined, 35-36 risk versus return in leveraged finance analysis, 33 risk s, subjective facto rs in, 85-86 R O E (return-o n-equity) analysis, 91 R O I (return-o n-investment) analysis, 91 S S& P, catego ries o f ratings, 18 sale o f co mpany during bank ruptcy, 231 sales and revenue mo deling, 96-98, 99-108 scenario s event scenario analysis, 33, 179-180 acquisition by issuer, 180-185 buyout of issuer, 185-189 debt maturity faced by issuer, 192-194 161 IPO announcement by issuer, 189-192 in forecasting, 108-109 securities mark et See leveraged finance security of corporate bank loans, 39 in debt rankings, 138 sell side o f leveraged finance, 22-23 senio r secured debt in debt rank ings, 140 senio r unsecured debt in debt rank ings, 140 sink ing funds, 126 snapsho ts o f credit, preparing, 239-242 spread for corporate bonds and loans, 41-43 defined, 11 relationship with yields, 43-44 spread to w o rst (ST W ), defined, 11, 44 springing maturity, 126, 164 Standard & Po o r’s (S& P), catego ries o f ratings, 18 statement o f cash flo w s capital expenditures in, 57-58 EBITDA derived from, 53-56 importance in analysis, 64-65 interest expenses in, 58-59 sto ck s, co rpo rate bo nds versus, See also equity structural issues in leveraged finance analysis, 32-33 structural subo rdinatio n in debt rank ings, 141-144 structured pro ducts managers, 25 ST W (spread to w o rst), defined, 11, 44 subo rdinated debt in bankruptcy claims, 227-228 in debt rankings, 140 subsidiaries, restricted versus unrestricted, 165-166 subsidiary guarantees in debt rank ings, 145-147 super-vo ting po w er in co mmo n sto ck , 198 syndicated lo ans See co rpo rate bank lo ans T taxes in financial statement analysis, 59 technical default curing, 173 defined, 8, 10, 163 162 tendering fo r bo nds, 135 tenders, 174-176 10% calls, 130-131 term lo ans defined, 35 tranches, 37 T E V (to tal enterprise value), determining, 201-206 “tighter,” 49 to ggle bo nds, 48, 120 to tal debt, 154 to tal enterprise value (T E V), determining, 201-206 to tal mark et enterprise value, 73 to tal returns, 45-46 “trading cheap,” 49 trading parlance, 12 “trading rich,” 49 tranche defined, 11 in term loans, 37 traps, avo iding, 248-250 trend analysis See business trend analysis U–V unrestricted gro ups, 165-166 valuatio ns See also ratio analysis in bankruptcy analysis, 230-231 of equity, 201-206 vo latility in leveraged finance, 27 W w aivers amendments versus, 170 to corporate bank loans, 38 w ho le bo nd issue, individual bo nds versus, 116-117 “w ider,” 49 W ilde, O scar, w o rk ing capital, changes in, 59-60, 80 Y yields for corporate bonds and loans, 12-13, 41-43 on deferred payment bonds, 46-48 163 duration, 45 relationship with spread, 43-44 yield-to -call (YT C ) defined, 11 explained, 43 yield-to -maturity (YT M ) defined, 11 explained, 43 yield-to -w o rst (YT W ) bond calls and, 128 defined, 12 explained, 43 YT C See yield-to -call (YT C ) YT M See yield-to -maturity (YT M ) YT W See yield-to -w o rst (YT W ) Z zero co upo n bo nds, 46-48, 115-118 zero -step co upo n bo nds, 118-119 164 In an increasingly competitive world, it is quality of thinking that gives an edge—an idea that opens new doors, a technique that solves a problem, or an insight that simply helps make sense of it all We work with leading authors in the various arenas of business and finance to bring cutting-edge thinking and best-learning practices to a global market It is our goal to create world-class print publications and electronic products that give readers knowledge and understanding that can then be applied, whether studying or at work To find out more about our business products, you can visit us at www.ftpress.com 165 ... finance markets than in the investment-grade market, which also aligns much of the analysis more to equity-like analysis than to traditional debt analysis Meanwhile, leveraged finance bonds and loans... diversification, currency, and geography A Pragmatic Point on the Various Aspects of Analysis The basic building blocks of leveraged finance credit analysis are based on liquidity and asset value analysis. .. C.V Pearson Education—Japan Pearson Education Malaysia, Pte Ltd Library of Congress Cataloging-in-Publication Data: Kricheff, Robert, 196 3A pragmatist’s guide to leveraged finance : credit analysis