Carve-out clauses and the quest for yield

By Francesco Rassu and Carmelo Spallino

The European bond market is still under the effect of ECB’s quantitative easing lowering yields to sub-zero levels and, on the stock market side of things, valuations are at all times high making the quest for an index-beating return even harder. This translates many investors to allot their funds towards junk bonds.

On the one hand, the thirst for higher yields has both lowered the cost of financing for not-investment grade bond issuing but also led to the easing of bond covenants terms favouring issuers; on the other, it has led to unforeseen consequences deriving from said easing, such as the insertion of the so-called carve-out clauses.

What is a carve-out then?

A carve-out transaction is the divestitures or sales of divisions or business units.

In practice, carve-out clauses also encompass certain loopholes such as the one in which a company’s restricted subsidiaries makes investments in “unrestricted subsidiaries”: in layman’s terms it means that the issuer of the bond can transfers company’s assets from said company, subjected to the terms of the bond covenants (restricted subsidiaries), to another entity not subjected to the terms of the bond covenants and thus effectively subtracting from the bondholders all or part of their collateral.

For example, Diversey, the cleaning products company, has recently tried to insert such clause in its issuing of high-yield bonds to back private equity firm Bain Capital’s acquisition of the business from Sealed Air Corp, allowing the company’s “restricted subsidiaries” to make investments in “unrestricted subsidiaries”, which would pass value from entities that bondholders have control over to those outside of their reach.

Not only are these clauses harmful to investors but, at times, have a bitter ending also for the other counterpart in the transaction, with many bondholders resorting to courts to uphold their rights.

In addition, these loopholes are often used in bouts of particular distress for the underlying company; in fact, the business often finds itself in the midst of a public battle between bondholders and the PE firm that has acquired it. One such example of this behaviour is the $31bn leveraged buyout by Apollo Global Management and TPG of Harrah’s Entertainment, renamed Caesars Entertainment after its best-known property, Las Vegas’ Caesars Palace.

The humungous leverage buyout was completed at the onset of the 2008 crisis, bought at a 31% premium reflecting the belief that casinos were a downturn-resilient business.  Unfortunately, that belief could not have been further off reality: with the essential convention business drying up and the servicing of $24bn of debt absorbing all the company’s cash flow, Caesars Entertainment filed for bankruptcy protection in 2015. Between 2011 and 2014 TPG and Apollo were pitted against their creditors – Elliott Management, Appaloosa Management and Oaktree Capital – due to a believed asset stripping committed by Caesars’ private equity owners to salvage the healthy assets in the business and at the same time evading the reach of the company’s bondholders.

On the one hand, the $5.1 billion from the asset sales were claimed to be fundamental to keep the company alive, on the other, not only were the properties sold at a hefty discount to their value but also by doing so Caesars Entertainment was left with the weakest assets and thus unable to satisfy bondholders. In the end, the parent Caesars entity controlled by Apollo and TPG  agreed to put $6bn into the restructured company, including handing back most of their equity ownership in Caesars to the overall creditor group.

Another glaring example of a carve-out clause in use is the so-called “J-Crew trapdoor” taking its name from the men’s retailer which was acquired in a $3 billion LBO by TPG Capital and Leonard Green & Partners. J-Crew transferred about $250 million worth of intellectual property to a Cayman Island-based unrestricted subsidiary with the aim of borrowing against the transferred assets and using the proceeds to repay (or otherwise redeem or exchange) structurally subordinated debt of its parent at a discount.

However, even though the transaction was portrayed as a way to offer some much-needed relief from the more than $1 billion debt weighing down on the company, on the other side of the coin, the bondholders have been stripped of their collateral which has been placed out of their legal reach. A testament to the popularity of this play is fellow retailer Neiman Marcus who has recently moved its MyTheresa brand into a similar subsidiary.

The aforementioned low-yield environment combined with the over-eagerness of many a bondholder for a decent return is paving the way for more and more relaxed terms in bond covenants favouring the issuers; the phenomenon is certainly worrying and we may hear soon again about the “J-Crew trapdoor” and similar clauses.

All that said, the tide may be about to turn with the scaling back of quantitative easing both by the Fed and the ECB which will ultimately translate into higher bonds’ yield and less inflated assets’ prices. However, in the short term investors need to be wary of these clauses in their quest for return.