Private equity firm KKR is taking a leaf out of rival Blackstone’s play-book by trying to sell a junk bond with very weak investor protections as it seeks to fund a leveraged buyout.
Covenant Review, which alerts the buyside to high-yield bond offerings with issuer-friendly provisions, has reiterated a call for investors to fight back.
The research company has honed in on a specific covenant called the US$1 of ratio debt test. That provision helps limit the ability of sponsors to pay dividends from cash that accumulates in the restricted payments basket.
Blackstone became the first sponsor to completely eliminate some of those bondholder safeguards last week in a deal to help finance its purchase of a 55% stake in Thomson Reuters’ Financial & Risk division.
That division will be called Refinitiv after the deal closes, and includes IFR.
KKR is now looking to do the same on a US$1.625bn junk bond sale to help finance its acquisition of physician services provider Envision Healthcare which it agreed to buy in June for US$5.57bn.
“Unless investors resist, it is unlikely to be the last,” Covenant Review analyst Scott Josefsberg wrote.
Typically, dividends cannot be paid out of accumulated restricted payment baskets if a company is in default, and unless its earnings are at least double that of its interest expenses.
But by eliminating the US$1 of ratio debt test in the Refinitiv bond, Blackstone gave itself unprecedented flexibility to move assets to unrestricted subsidiaries if the business ran into financial difficulties.
“The Refinitiv bonds have successfully cleared the market, with all the flaws and loopholes intact, creating a new beach-head for covenant dilution that other issuers and sponsors will seek to incorporate in new transactions,” Josefsberg said.
“Now KKR wants the ability to take out dividends and other distributions to equity whenever, regardless of the financial health of the portfolio company.”
NOT SO EQUAL
But that is not the only thing bondholders need to mull.
There are other provisions concerning asset sales that could be negative for bondholders, several market sources told IFR.
Envision is one of the biggest US providers of physicians to hospitals and also owns AMSURG, an ambulatory surgery centre that offers patients a cheaper alternative to hospitals.
A banker close to the deal said the financing had been structured to give KKR flexibility to sell the high-margin AMSURG business without paying off all the company’s debt.
“KKR is definitely contemplating the sale of the AMSURG business and it probably makes sense,” Bill Zox, chief investment officer at Diamond Hill Capital Management, told IFR.
“Wouldn’t a hospital be reluctant to contract with Envision to operate its emergency room, only to divert patients to AMSURG’s surgery centers?”
The general rule for asset sales is that all proceeds are used to pay down senior debt, or to reinvest in the business, one analyst told IFR. But sponsors often try to weave in exceptions as to what qualifies as an asset sale, and so is KKR.
Documents for the US$1.625bn high-yield Envision bond seen by IFR show that for a specified sale of ambulatory services assets, KKR can pay itself a dividend if it satisfies one of two conditions.
It either has to pay down the US$5.05bn leveraged loan and the US$525m privately placed high-yield bond by roughly 68% (calculated by IFR) of the net proceeds of the asset sale, or cut that debt to bring down leverage to 6.95x. Whichever is greater.
The estimated pro forma leverage for Envision is 6.9x, according to the same bond document.
That suggests as long as the company’s leverage does not get any worse, and a certain amount of proceeds from a sale is used to pay down the loan and privately placed bond, KKR can take out a dividend for the remaining cash left from the sale proceeds.
“Bondholders would be left with a less diversified business,” one investor told IFR.
Covenant Review’s Josefsberg told IFR this was an unusual provision, and potentially leaves the buyers of the US$1.625bn bond deal in a weaker position to other lenders.
“A high-yield asset sale covenant is supposed to treat all equal ranking debt equally. But this prefers the privately placed bond over the US$1.625bn issue even though they are both unsecured and pari passu.”
It remains to be seen whether KKR will have the same success as Blackstone on the Refinitiv bond, which was massively oversubscribed and priced at lower yields than originally expected without any changes to the bond provisions.
Citigroup, left lead on the Envision bond, is testing investor appetite for the eight-year non-call three year issue at a yield of high 8% to 9%, a banker on the deal told IFR. That is higher than the 8.25% yield on the Refinitiv unsecured bond.
Meetings with bond investors began Monday and finish Friday.
“The fact that investors have been willing to allow for the removal of these kinds of provisions shows you how far the pendulum has swung,” said one analyst.
“Everyone wants to negotiate the best set of terms for themselves, and this is what the market is bearing. If you don’t ask, you don’t get.”
Credit Suisse is leading the US$5.05bn loan. The deadline for lender commitments has been pulled forward to September 26 from October 1.
Morgan Stanley, Barclays, Goldman Sachs, Jefferies, UBS, Royal Bank of Canada, Societe Generale, HSBC, Mizuho, BMO, SunTrust, Credit Agricole and KKR Capital Markets are also joint bookrunners on the bond and loan sale.
Citigroup and Credit Suisse declined to comment. KKR was not immediately available to comment.