DIC Restructuring: Difficult Discussions Over Margin and Covenants?

Asa Fitch over at The National reports that discussions between DIC and its creditors over the proposed five-year rescheduling are focused on:

1. The margin. DIC would like 85 bp.  The lenders appear to be sensibly asking for more.  Though the precedent set by Dubai World's rescheduling is not in the lenders' favor.
2. The lenders would like covenants triggering default if certain levels of asset sales aren't met in the second and fourth years of the restructured facility.

While Asa's sources describe the proceedings as "fierce", the Company itself sees things proceeding smoothly.  

I suspect this will end up with a cosmetic change in the margin.  Hopefully, the banks have their eyes firmly on the prize (the more important point):  covenants to force asset sales.  An extra 100 or 200 bps is going to be cold comfort, if the banks can't force the return of their principal.  

There's nothing like the reluctance of an investor who bought at the top of the market to sell when markets are depressed.  He knows there's real additional value there and he has the loans to prove it.  Plus do I need to add The Vision.

DIC Asks for More Time

According to the Khaleej Times DIC has asked the lenders on its US$1.25 billion facility to extend the maturity until the end of November. Earlier it had been extended from the end of June until the end of September.  The article also states that the Company has circulated a draft rescheduling plan that envisions asset sales over a five to seven year plan.  

“They [DIC] are buying some time because markets go in cycles and currently assets are stressed and below their value,” said Haissam Arabi, chief executive and fund manager at Gulfmena Alternative Investments.

“We are on our way to reach a new cycle as soon as the fourth quarter...when we will see valuations and share prices expanding,” he said. DIC had already extended the $1.25 billion loan, which matured in June, to September 30. 

Sadly we learn that markets often undervalue assets from their true value (the value imagined by the holder) for long times.

And equally sadly, while it appears the Obama Administration's stimulus plan is working, it seems that tangible effects won't be felt until after the November elections.

Earlier post here.

Dubai World: The Impact of the Fixed Interest Rate on Secondary Debt Prices

FOR SALE 

 

Great Price.  One Owner Only! 
Carefully Underwritten and Maintained

Asa Fitch over at The National has a report on secondary loan sales of DW debt.  As per his report only US$25 million has been sold so far by an unnamed Asian bank at US$0.55 of par.

Traders are quoted as saying there is a disconnect between the bid and offer prices with sellers looking for modest discounts and buyers thinking more in the range of 30 to 60% discounts.  That's an extremely wide range - which indicates the lack of real demand.  Also it may be reflective of differing discounts for the five-year and eight-year paper.

For a potential buyer there are two key risk issues with a purchase:

1. Repayment Risk - Will DW settle its debt in full?  So there is a premium added to the "risk free" yield to compensate for this risk.
2. Interest Rate Risk -  DW's debt is at a fixed not floating interest rate.  The price of financial instruments with fixed interest rates moves inversely to the current market level of interest rates.   If you think about that it makes perfect sense.  If the market if offering to sell you a new bond with a fixed 5% coupon, why would you pay the same amount for an equivalent credit risk bond with a fixed 2% coupon and the same repayment profile? You'd be willing to buy the 2% bond only if its price were less than par.  Sufficiently less so that you earned 5% on  the bond. The extra bit of yeild coming from capital appreciation.  This price risk exposure is measured by duration and convexity. Duration estimates the price change using a linear approximation of the price change function (equation).  Since the actual function is not linear, a second approximation, convexity, (technically the second derivative) is used to correct the first. Bond sensitivity to interest rates can work both ways.  If market interest rate levels decline, then one's bond is worth more.  That is, reversing the example above, one has the 5% coupon bond in the 2% market coupon environment.  As noted above in the original example, if market interest rates increase, one's bond is worth less.  Since DW's bonds are at below market rates and since market rates are at historic lows, there is little upside potential.  Any buyer will be focused on pricing the downside risk into it's bid.  Compounding the pricing will be the credit risk element.  Just to complete the discussion, floating rate instruments are less much sensitive.  Their duration is generally equal to the length of the repricing period not a function of maturity.  With, for example, a quarterly interest payment reset one can ignore interest rate risk.

These two factors affect the discount.  The bigger the required yield on the instrument the bigger the discount.

Since I haven't seen much discussion of interest rate risk, and since I think it's an important factor affecting the secondary pricing of DW debt, I'm going to focus on it in this post as you may have guessed from my "succinct" discussion of this topic immediately above.  

This is a structural issue.  As the restructuring was crafted, lenders had two options to reflect the economic value of the debt.  

1. Haircut the debt and get a market or near market rate on the debt. 
2. Maintain the fiction that the debt was worth par and take a below market interest rate.

Why did they choose the structure they did?

Some potential explanatory factors:

1. The importance of cashflow to DW.   DW is cash strapped.  A higher interest rate will impact them more now than reduced principal repayments which in traditional restructuring style are going to be backended.  DW's overriding goal is to delay as long as possible the sale of assets, hoping that an economic recovery will allow them to realise more value.  Or that  a refinance will become possible.  Particularly important because a lot of these were purchased at the top of the market with more than modest levels of leverage. 
2. The wise lenders in the steering group who have the remarkable accomplishment of being responsible for 60% of DW's debt (Another great moment in banking!) are probably not going to be selling because the pain would be too great.  It's much easier to absorb say an US$11 million loss on one's US$25 million stake than say a US$2+ billion loss.  So they have no burning incentive to  create a more seller friendly structure.  They're holding at cost not marking to market.  Assuming DW performs under the restructuring, their "haircut" will be the IAS#39 mandated one time present value difference using the new interest rate versus the older higher one.
3. Forgiving principal sets all sorts of dangerous precedents and raises all sorts of dangerous ideas in the minds of borrowers.  
4. Also since interest rates can't go negative, an interest rate reduction has an absolute bound in terms of the haircut.  
5. Additionally, many folks don't understand the concept of present value so an interest rate reduction is not considered as serious as a principal reduction.  You might be surprised (and maybe some of you dismayed) to learn that in many institutions a principal reduction requires a more stringent approval than an interest rate reduction - even when the present value impact is the same.   With the financial press and the average investor the awareness appears to be even lower.

 As usual,  let's begin with the assumptions:

1. A market-demanded discount of 50% of par.   Roughly in the midpoint of the mentioned discount rates.
2. An average 5 year life for the 8 year DW restructured loans.  Since we don't know what the principal repayment schedule is, we have to assume an average life.  I think five years is a good guess. DW's repayments probably mirror the pattern typical for restructurings:  low payments in the first years with the largest in the latter years.  If equal amortization would result in a bit over 4 years average life, then 5 years should be on the safe side. Use of 5 years then sets what I think is a reasonable upper bound to the YTM.  In any case hopefully enough for a directional analysis.  Hint:  I will gladly receive a copy of the  restructuring term sheet if anyone wants to send it to me.  Use the Contact Form to make the initial contact to agree transmission details.
3. A 2% (fixed) coupon.
4. Repayment in full on schedule assumed.

Here are the numerical results.

We can bound the yield to maturity on the 8 year tenor loan between two  points.

Yield to Maturity ("YTM")

1. Assuming a straight bond with a bullet repayment of principal at the end of Year #8, the YTM is roughly 12%.  While interest payment frequency affects the YTM, the difference is minor.  For our directional analysis, I'm therefore going to ignore it.  12% represents the minimum YTM because the restructured loans provide for principal repayments during the life of the loan not just at the end.
2. Using a 5 year average life, the rough YTM is 17%.

Modified Duration

1. For the straight 8 year bond, duration is very roughly 7 times.
2. For the straight 5 year bond, duration is very roughly 4.5 times. Recall that as above we're guesstimating that the average life of the loan as 5 years.
3. What that means is that if  interest rates increase 1% with no change in default risk (credit rating of DW) and no change in credit spreads (the margin demanded for a specific credit grade), then the DW debt will lose roughly 4.5% of its market value. I've chosen to ignore convexity here because it's not likely to be a significant decrease of the duration impact for  the range of likely market interest rate levels.  Since over the next five to eight years, interest rates are more likely to go up than further down, this is a real risk.  A modest 2% hike in interest rates and there is a 9% loss - which will more than outweigh the coupon earnings.
4. Of course, for an investor who intends to hold the bond to maturity, the price loss will be a mark-to-market event and not necessarily a cash flow loss.  Unless of course the investor sells the bond.  However, a fund or a trader will be marking to market and thus performance will be affected.    With a direct impact on such personally important things  for a fund as fees and reputation for the next fund sale. Or for a trader his bonus and perceived trading skills. You can probably easily imagine how these might increase reluctance to increase one's bid, particularly when demand is minuscule in relation to supply.

Other Factors Affecting Demand

1. Secondary Play:  There is no secondary play here.  Often in distress situations, buyers of debt may be motivated by the chance to acquire a company cheaply (buy the debt wipe out the existing shareholders) or other factors.   Emirates Airlines or Emirates NBD are not on offer.   The restructuring is "done and dusted" so there's no negotiating leverage over deal terms.  And one would have to make quite an investment to acquire a blocking vote on the chance there would be a future covenant hiccup that one could take advantage of.    One of our regular commentators, Laocowboy2 mentioned a time-honored sovereign debt settlement mechanism - using the debt as the currency for investing in a new project in the country.  Often with the debt being exchanged at par (not its purchase price) and sometimes at a favorable FX rate which effectively lower the cost of the investment.  Many an savvy investor in Latin American tourism reaped a bonanza return using this framework.  Others who invested in more brick and mortar enterprises less so.  Hint:  An investor's return in such transactions depends more on the creative use of imaginative transfer pricing than one's ability to run a business, though the latter is important.  In any case,  I suspect it is unlikely that Dubai will offer such a program.  The sovereign debt "hole" here is not that deep. Nor the distress that acute at present.
2. Credit Rating Upgrade:  While the "hole" is not that deep, there is still a hole.  Assuming good performance, at some point DW will be upgraded.  However, this is unlikely to happen in the near term.  By the time significant debt is repaid, it may be so close to final maturity that the impact on YTM may be relatively modest. As well, the structural fact that the debt is at a below market fixed rate is going to work against any significant increase in the price.   
3. Credit Spread Compression:  Usually this occurs in times of irrational exuberance.  Judging by the state of the world economy, a near term return to such giddy days is perhaps not a bet a savvy investor would make today.  And again the very low fixed rate is a negative.
4. Prepayment:  It's unlikely that DW is going to prepay the loan in the near term. If it did,  the YTM could dramatically improve. With a rate this low there is an incentive to ride to maturity. Presumably, the desire to "repay" the restructuring and remove a living blot from its escutcheon would be a motive to refinance (when that was possible).  More importantly, it could alleviate cashflow demands, including the requirement to dismantle its expensively acquired empire of  "core" investments.  The unknown is when banker and investor ADD will kick in and permit a refinance.  A good guess is probably more than 3 years out, particularly as the upcoming US$30 billion of new maturities over the next 2 years will remind the apparently congenitally forgetful and heedless of the "hole".

Dubai Holding: Some Creditors Selling Debt

Asa Fitch over at The National reports that some creditors are looking to exit their exposure to Dubai Holding - DHCOG and DIC - through secondary sales at a hoped for modest discount.

This makes eminent sense in view of the many indirect costs associated with carrying distressed debt.  Costs of additional internal reporting and monitoring for credit purposes as well as for accounting purposes (both book keeping and disclosure).  

On top of all of this, if a creditor feels there is the possibility of an impairment, the decision to close the file  now, recognize the loss and move on may be highly appealing, particularly if there is no long term relationship.  Or if such a relationship is not perceived as being sufficiently profitable in the future.

Clearly, this strategy does not work with banks holding sizable shares.  Unloading a $5 million or US$10 million "bit" is a lot less painful than $50 million or US$100 million.

DIC Cashes Out of Merlin (Madame Tussaud's)

Asa Fitch over at The National reports that DIC has sold its remaining 6% stake in Merlin to CVC.  No doubt an element of cash need drove the sale, though DIC received the lion's share of its return in 2007 when it received GBP 1 billion in cash plus 17% of Merlin.  This is compared to the purchase price of GBP800 million in 2005.  

The additional amount for the sale to CVC is icing on the cake.

According to CVC's press release on the sale, the ownership of the Company is now KIRKBI 36%,  Blackstone 34%, CVC 28%, management 2%.

With no single investor holding majority control, managing the Company will be a bit trickier than if there were a dominant shareholder.   

On the other hand, a distinct benefit is that cash calls for new equity (if any is required) will not fall disproportionately on any one shareholder.  

The Company needs cash to fund its "ambitious growth programme" as the CVC press release states.  And there is the unfortunate bunching of loan maturities - the extension of which is being negotiated currently.  Both potential cash demands.

Additional debt financing is unlikely.

The CVC press release also states that "Merlin does not intend to increase its financial leverage."   I suspect that the decision reflects more than sober financial self-discipline. Bankers are now less willing to lever up the company than they were during the  "Bonny" days when Charterhouse owned Madame Tussaud's.  Then loans were abundant.  And with easy terms - long dated bullet loans.    

That leaves additional equity.

Last October, the Financial Times reported that Merlin would IPO in 2Q10 with the transaction mooted at some GBP2 billion.  The sale to CVC suggests that the IPO route is not as likely as there is little reason for Blackstone to reduce its position in a trade sale if an attractive IPO is imminent. 

The remaining source is private equity - and perhaps a rationale for several rather than one dominant shareholder.

Dubai Rescheduling Watch - Dubai International Capital

An article from The National provides a bit more detail on DIC's asset sales and remaining assets as well as its debt postponement.