Cash & Liquidity ManagementInvestment & FundingCapital MarketsBeware the Dreaded ‘Make-Whole’: Private Placement Insurance Company Debt

Beware the Dreaded 'Make-Whole': Private Placement Insurance Company Debt

You’re a CFO. Times are good, and you receive an offer you can’t
refuse – 7-10 year, $100 million term financing. No bothersome collateral.
A relatively low fixed-rate coupon for such a maturity – call it 5.50
percent. A pre-negotiated term sheet leading to reduced lawyer haggling and,
ultimately, reduced transaction costs. Sounds good, right?

These are the earmarks of the traditional private placement debt market –
a corporate debt market provided by U.S. insurance companies that indeed constitutes
one of the true cornerstones of American finance. And over the years, many CFOs
across the country have in fact signed on the dotted line and have tapped this
important market for their corporate debt.

For many, it has been absolutely the correct decision. The private placement
insurance company debt markets do provide relatively low-cost, long-term, unsecured
financing. However, if the economy suffers, corporate profits swoon and lenders
start instituting defaults, a two-word phrase can be heard ringing down the
halls of corporate America – “make-whole.”

The Refi Pain

You’re a CFO, and now times are not so good. Your company is no longer
investment grade, and is in default under the financial covenants contained
in the private placement debt agreement pursuant to which these long-term, fixed-rate
unsecured notes were issued. You’ve missed your numbers and missed your
covenants. The insurance company lenders that bought these notes have told you
that they want “out.” They demand that you refinance the notes.
And, adding insult to injury, they demand payment of a prepayment premium of
sorts – the dreaded “make-whole”

“Make-whole” may not sound so bad, but, unfortunately, the “make-whole”
amount can be a really, really, big number – a devastatingly large number.
For example, for some recent refinancing deals ranging between $90 million to
$200 million, the make-whole amount ranged from $13 million to $22 million.
Ouch! For some perspective, imagine if you had to pay a $75,000 prepayment premium
on your $500,000 home mortgage – it’s about the equivalent.

Defining ‘Make-Whole’

Make-whole is the term used to describe the amount over par that the issuer
of notes is required to pay in the event the issuer desires to, or, as is quite
often these days, is required to, prepay or refinance the notes prior to their
stated maturity.

The make-whole amount is calculated by determining the present value of the
interest that would have accrued on the notes through their originally stated
maturity, all as if the notes had not been prepaid. The present value calculation
uses a discount factor, referred to as the “reinvestment yield,”
equal to the treasury rate corresponding to the remaining maturity of the notes
(plus, typically, 25 or 50 basis points).

The reinvestment yield represents what the investor can now theoretically earn
by reinvesting the prepaid principal in a relatively safe investment. Not surprisingly,
given its name, the make-whole feature is designed to give the investor the
benefit of its economic bargain as if the notes were held to maturity and to
make the investor whole, notwithstanding the early prepayment.

Further, make-whole is payable not only when the issuer voluntarily prepays
the notes for its own internal reasons, such as a recapitalization of its balance
sheet or a refinancing to reduce interest expense. Rather, insurance companies
insist upon – and private placement loan documents will invariably provide for
– make-whole even when it is the insurance companies themselves that call
a default and force the issuer to refinance them out.

It is this “forced refinancing” scenario that is most disturbing
to CFOs. Paying a premium in the case of a voluntary prepayment is one thing.
After all, it is the issuer that is depriving the noteholder of the benefit
of the remaining interest-payment stream. But it is quite another matter, from
the perspective of the CFO, if his or her company is being forced to refinance
the notes because the insurance companies are not willing to waive covenant
violations beyond the control of the issuer. It is the payment of a make-whole
premium in this context that is most distressing.

Insurance companies will argue adamantly that such yield protection is the
price of a relatively low, long-term, fixed rate. Borrowers will argue that
the insurance company lenders should not be compensated for the entire portion
of the interest they would have received, since they are not making an outlay
of cash, and therefore an outlay of risk, during this entire time. But regardless
of who is right and who is wrong, it is the CFO that must account for this hit
to net income.

Pre-Closing Considerations for the CFO

Before signing onto the issuance of private placement insurance company debt,
CFOs should understand the potential extraordinary impact of make-whole in an
early refinancing context.

  • First, understand the amounts involved. Run some projections assuming prepayment
    in the first years of the deal, using your best estimates as to where interest
    rates will be at those times. Understand the extent of the make-whole risk
    your company is undertaking.
  • Second, like any financing, obtain the most lenient financial ratio covenant
    package you can negotiate. The longer your company stays out of default, the
    longer you can avoid the dreaded forced refi scenario and reduce or eliminate
    the dreaded make-whole itself.
  • Third, proceed cautiously if your company is especially cyclical or is in
    an industry sector that could face a downturn. Otherwise, basically sound
    but cyclical businesses can often stumble on the financial covenants, resulting
    in a potential forced refinancing.
  • Fourth, because make-whole is payable in a voluntary prepayment context
    as well, consider whether there are any potential transactions or events on
    even the mid-term horizon that could fundamentally change the company’s
    corporate structure or character. Examples include a potential change of control,
    a significant equity issuance or other recapitalization or a significant acquisition
    or divesture. If such events are likely, either build them into the agreement
    so that they are permitted or carefully consider whether the private-placement
    market is for you.
  • Fifth, consider other long-term financing alternatives, including the public
    debt markets. Yes, public bonds do typically contain extended no-call periods.
    Further, even when the bonds become callable, they come with substantial premiums.
    However, the key difference between public debt and privately placed debt
    in this regard is that public debt instruments do not contain financial ratio
    maintenance covenants that give rise to the dreaded forced refinancing scenario.
    As a result, it is far easier to stay out of default with public debt. The
    transactions costs may be higher but the make-whole risk is reduced.

When Make-Whole Stares You in the Face

So, what do you do when you are looking at a $15 million make-whole payment
in a forced refi scenario? Negotiate. For the most part, experience has shown
that insurance companies will forgo all or a portion of the make-whole in exchange
for receiving 100 percent of their principal if they sense a true distressed
or workout credit.

But, to get to this result, you must either actually be poor or cry poor effectively!
Obviously, actually being poor has its own hurdles – first and foremost
of which is the ability to obtain refinancing in the first place. If the issuer
is in a tenuous position financially, it may be unable to obtain sufficient
refinancing to repay principal, much less make-whole.

However, if the issuer can obtain alternate refinancing, crying poor effectively
is still tricky. The issuer must demonstrate to the insurance companies that
it has just enough collateral or cash flow to refinance the notes at par but
not enough to pay any additional make-whole amount. While this can often be
the true state of the issuer’s financial affairs, it is often difficult
to convince the insurance companies of this fact.

Depending upon the gravity of the situation, the insurance companies may waive
the make-whole. For instance, a series of failed refinancings is an obvious
signal that the issuer has real problems and, if presented with a refinancing
that pays principal at par but no make-whole, the insurance companies may very
well take that deal.

Often, if cash or collateral is tight, insurance companies will accept deferred
subordinated notes or preferred stock or other equity, or simply reduced make-whole,
depending upon a range of factors. These include the amount of make-whole involved,
the issuer’s true (and perceived) financial state, the intransigence of
the noteholders and, perhaps, the effectiveness of issuer’s counsel.

Also, CFOs are encouraged to be skillful in playing groups of lenders against
one another. Commercial banks despise make-whole just as much as the issuer
that is obligated to pay it. The banks can place pressure on the insurance companies
to accept a refi that pays less than the full make-whole amount. If the issuer
can present a picture of true financial distress, some or even great success
can often be had.

In this same vein, attempt, with the aid and comfort of other lenders, to subordinate
the make-whole portion of the insurance company claims in any intercreditor
negotiations-whether before or after default. As a corollary, avoid whenever
possible securing the make-whole obligation with any collateral security. The
lower the make-whole is in the waterfall of payment, the greater chance for
success in avoiding or reducing make-whole. Sometimes, your other lenders can
be your best friends.

Richard W. Grice is chair of the Leveraged Capital Group of Alston & Bird,
a national law firm headquartered in Atlanta.

This article first appeared on Financial Executive Online, November 2003.

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