Collateral: Great Expectations vs Sobering Facts

Expectations Often Are Not Fulfilled

 

Ellen Carr has an article in the 10 June FT “Linus from Peanuts has risk lessons for high-yield investors”

Two quotes from that article to set the stage for some additional observations.

When we get the chance to buy bonds with collateral backing them up, we feel, well, more secure.

Secured bondholders anticipate that, if their research fails them and the issuer ends up in bankruptcy court, they are likely to be paid in full before unsecured lenders get a dime.

There is truth in these statements.

But note that in both of the quotes Ms. Carr speaks about “feelings” and “anticipations”.

Sadly these “wishes” don’t always turn into “horses” that bond holders can ride.

Some inconvenient and perhaps even “sobering” facts.

(H/T for the latter phrase to Joseph Blount, President and CEO of Colonial Pipeline).

The nature of the collateral drives its value in a liquidation.

1. Property, plant, and equipment generally are sold for a fairly low percentage of historic cost in collateral realisation, particularly if they are highly specific to an industry. Or are costly to move.

2. As you’d expect items nearer to cash have higher sales values, assuming they are liquid in nature and trade in liquid markets.

3. Holders of collateral in the form of 100% of the shares of capital stock in a subsidiary are effectively junior in legal priority to all other creditors in that subsidiary. Last in the line in the cash waterfall from the subsidiary’s estate.

4. Such shares are generally less liquid than listed shares.

The nature of the corporate distress drives collateral values in liquidation.

1. If one company in an industry is failing but the industry itself has reasonable prospects, the sales price of collateral is likely to be more than if the entire industry is tanking.

2. This will also depend on whether there is existing excess capacity in the industry.

The form of the corporate distress resolution can affect access to collateral.

1. In a US Chapter 11, one may find one’s position changed under the reorganization plan.

2. Realisation of collateral can be legally stopped.

3. The reorg plan may change tenors, rates, and in some cases even the collateral itself.

4. In that regard DIP financing can create a new and higher priority class of secured creditors.

Laws and transaction structures can affect collateral.

1. Be sure that you legally have and can enforce your collateral rights.

2. Be sure the legal structure is sound. Complex structures involving multiple national laws may be fragile. You enforce your collateral rights in the jurisdiction where the collateral "resides".

3. Read the Offering Memo. The deficiencies outlined in points #1 and #2 above are often clearly spelled out in the Offering Memoranda. (See earlier posts on Golden Belt Sukuk and Peking University Founders Group),

4. Be sure you will get a fair shake in courts if you have to enforce your rights. For example, you don’t really want to be a foreign lender in Saudi Arabia. (See Al Gosaibi, TIBC, AlAwal Bank, AlSanea. Or Redec for those with long memories or access to the internet.)

5. Be sure there are no quirks in local law or advantages for well connected individuals. (See Dana Gas posts).

With that as background, let’s take a look at the transactions she mentioned in her article.

What's the Scrap Value of a Cruise Ship?

Royal Caribbean Line: US$ 3.320 billion senior secured notes maturing in 2023 (US$ 1 billion) and 2025 (US$ 2.320 billion)

You’ll find the Indenture here.

Collateral – pages 7-8

“Collateral” is defined as:

1. shares of capital stock in subsidiaries that own the pledged “vessels”

2. 28 pledged vessels

3. the Collateral Account and any “Trust Moneys” within

4. the material trademarks owned by the Issuer and Celebrity Cruises Inc. on the Issue Date, including the Royal Caribbean and Celebrity brand trademarks and (y) all intellectual property rights of the Issuer in and to marketing databases, customer data and customer lists, except to the extent prohibited by contractual obligation existing on the Issue Date or applicable law, rule or regulation.,

You may have read that the book value of the pledged collateral is some US$ 12 billion.

Sounds great!.

That’s roughly four times coverage of the Secured Notes.

But let’s look a bit closer.

First, this collateral is industry specific.

Ask yourself what is the value of cruise related collateral if RCL is failing because it cannot generate sufficient cash to repay its debt.

Then ask how the fact that the cruise industry in general is “facing rough seas” may depress collateral values even more.

A falling tide lowers all boats.

And their related values. And that of their customer lists, trademarks, etc.

Second, note that the US$ 12 billion is based on historic cost.

It’s an old rule of the market that one sells assets at the current market price which may be significantly different than historic cost or book value.

If you are a motivated seller, bidders are more likely to bid low than high. If indeed, they bid at all.

But as they say on late night TV, “but wait there’s more”.

Third, Collateral Cap – pages 8 and 99

That’s not a sartorial accessory for the collateral,

But a way to deal with indentures in existing bonds which limit the amount of “new indebtedness” that RCL can incur.

So what is a collateral cap?

Let’ turn to the Indenture for the legal meaning of this term.

First, the amount of the collateral that is available to the secured creditors solely is limited.

“Collateral Cap” means, on the Issue Date, $1,662.0 million, as it may be increased pursuant to Section 4.13.

Second, on page 99 there is an explanation as to what happens to amounts above the “cap”.

In no event shall Collateral Proceeds in excess of the Collateral Cap or any other limitation on the extent of Collateral Proceeds contemplated by the Security Documents be applied in accordance with this Section 6.10, and such excess amounts shall be returned to the Issuer, any Guarantor or any other obligor of the Notes, as their interests may appear, or as a court of competent jurisdiction may direct.

So in the best case the collateral will not repay more than roughly 50% of the outstanding debt.

Any proceeds from the collateral sales over US$ 1.662 billion would go to RCL’s “estate” to be shared by all creditors.

Thus, the secured note holders are not going to be repaid in full before the unsecured creditors get a dime in the event that the collateral needs to be realised.

There’s more.

As is typical the Indenture permits certain liens against the collateral that have legal priority to the secured note holders’ position.

Once one takes possession of collateral like a vessel, one incurs maintenance and costs associated with berthing, including any required crew salaries and expenses, plus insurance until the sale. These out of pocket costs would then represent a deduction from the proceeds of any realisation.

Admittedly An Extreme Case
But Who Is Going to Want to Buy Stores Now?

Macy’s US$ 1.3 billion 8.375% senior secured notes maturing 2025

The notes are secured by first liens/deeds of trust on real estate.

If Macy’s hits the wall to use a technical financial term, does that perhaps indicate that retail is in real trouble?

I’d argue that it does.

Macy’s is indeed a different “fish” than say Sears or K Mart.

If a name like this is in trouble, then the sector is in trouble.

Who then is the expected buyer of these real estate assets or as we might more realistically call them “empty stores”?

Dollar General? Maybe if the price is a dollar?

What is their value in alternative uses? 

Amazon fulfillment centers? Homeless shelters? Schools?

If you’re interested, Fitch assigned this issue a BB+ rating.

That is below investment grade, a good indication that full repayment is not assured.