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$3.8bn bid may junk ISS bonds as loan mart cheers

Tuesday's $3.8bn bid for ISS, the Danish cleaning services group, by private equity firms Goldman Sachs Capital Partners and EQT has set up a direct clash between the interests of loan and bond investors.

The prospect of such a large buy-out is welcome for leveraged loan investors, which are cash-rich and hungry for assets. EuroWeek hears that Citigroup and Goldman Sachs are arranging the debt financing.

But for the company's bondholders it has had a completely different effect, hammering prices and raising the threat of a multi-notch downgrade to junk.

The developments — a classic example of what bond investors call 'event risk' — have reignited the smouldering calls for bonds to carry covenants to protect investors against ill effects of a restructuring or change of control.

"ISS is not junk grade yet but it should be some time soon," said Etienne Gorgeon, fund manager at Axa Investment Managers in Paris."In the meantime, the 2014 bonds have lost between 25% and 30% of their face value and the 2010s 15%, and there is absolutely nothing we can do."

ISS's board has yet to recommend the cash offer, which has been made through investment vehicle PurusCo. But Franklin Templeton, the largest shareholder in ISS with a 9.1% stake, has agreed to the tender.

ISS is listed on the Copenhagen Stock Exchange. The bid is worth Dkr470 a share, a premium of 49% over the company's average share price for the 12 months to March 23.

On Tuesday, Standard and Poor's placed ISS's investment grade BBB+ long term and A-2 short term ratings on CreditWatch negative. It said a downgrade of "several notches" could not be excluded if the takeover went ahead, because ISS's debt could grow materially.

The buy-out could raise the company's leverage to as much as six times Ebitda, according to one banker.

ISS issued Eu500m of 10 year 4.5% bonds in November. By yesterday (Thursday) their price had plummeted 25 percentage points from par to 74.00/75.00 since the announcement of the bid.

The company's Eu850m of 2010 bonds were not as badly affected and traded down to 90.00/91.00 because market players expect that the lenders on the new financing will insist on those bonds being taken out of the new capital structure.

Stephen Wilson-Smith, head of credit research at M&G Investments in London, said the ISS situation highlighted the need for covenants on bonds, and hoped it would raise investors' awareness.

Loans are typically documented with covenants that protect investors when a company changes hands, but investment grade bondholders do not normally enjoy the same protection. The one exception is sterling bonds for UK issuers.

A covenant in action

"There have been two examples of takeovers in the last two weeks, one the French property company Gecina and the other ISS," Wilson-Smith said. "Gecina had a restructuring event provision in the bond indenture that would result in a put at par, and the bonds lost just a couple of points in value, dropping from around 103.00 to the high 90s."

Gecina had included the covenant in its deal because of the high event risk associated with property companies, which can be a prime target for asset strippers.

Spanish real estate company Metrovacesa is still waiting for French regulators to give it the go-ahead for its Eu5.5bn takeover of Gecina.

Wilson-Smith said ISS was the first time he could remember a continental European company potentially sinking into speculative grade as a result of a buy-out. The other firms were UK businesses and not well known.

"This is a larger transaction than what we have seen, so I am hopeful that it will raise awareness of the need for better covenants," Wilson-Smith said.

Gorgeon at Axa agreed. "For companies like ISS, which are not too big and have no fixed assets, we should ask for covenants," he said. "When the market was very strong, companies could push deals through whatever the structure, but now everything is reminding us that if you do not have the right protection package attached to a bond, in the end investors are just left to suffer."

M&G co-authored a report with the Association of British Insurers last July calling for reforms of the euro and sterling bond markets, such as promoting the use of covenants.

The ABI, whose members manage more than £1tr of assets and hold at least 40% of all sterling bonds, published a four-page position paper in July 2004, entitled 'Standards in the Sterling and Euro Fixed Income Credit Markets'.

The manifesto consolidated and confirmed the work of the 'Group of 26' sterling and euro investors, which called in 2003 for greater disclosure and use of covenants.

Led by Barclays Global Investors, Gartmore Investment Management and M&G, the investors published a paper in October that year, listing seven areas in which they believed changes would make the Eurobond market more efficient and less volatile.

One of those was introducing a change of control provision, which would give investors a put option at par — or the reference government bond plus launch spread — if a company was taken over and downgraded, normally to below investment grade.

But issuers and investment bankers at the time said the provisions were too stringent.

In the bull market for credit that has prevailed since then, issuers have had virtually a free rein to command, not only tight spreads, but virtually covenant free transactions. 

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