Private Placement Bonds: Shedding light on a valuable alternative
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1 MAY 2013 Discover Value. Private Placement Bonds: Shedding light on a valuable alternative Private placement bonds, a valuable segment of the fixed income securities market, offer institutional investors significant opportunities. Private bonds offer investors enhanced yields, covenant protections and increased diversification. While the rewards are significant, the level of expertise and resources required pose a notable barrier to entry. Private bonds demand extensive due diligence. Investors must have considerable legal, credit and back office resources and expertise in order to evaluate, negotiate, underwrite and monitor private bonds. Building those capabilities requires time and resources, which is why investors may form a relationship with a firm that provides such expertise. Private bonds are best suited for investors with intermediate and long-term maturity needs and the capacity for reduced liquidity in a portion of their portfolio. In the search for yield, private bonds merit careful consideration. This paper takes a closer look at the private placement market, at who buys and sells private bonds and at the requirements of a successful private bond program. Lifting the Curtain on Private Placements Private placements are unregistered debt securities sold directly in the private market. They combine features of public corporate bonds and bank loans, offering the longer duration of fixed-rate corporate bonds while providing similar legal protections to those found in commercial loans. Private bonds are issued for the same purposes as public bonds: refinancing debt, expansion, acquisitions, fundraising to take a company Insights Higher relative yields and covenant protection compensate for lower liquidity Issuers are primarily investment-grade companies seeking diverse funding sources A multitude of names not found in the public market help diversify corporate exposure Borrowers with custom funding needs use the private market for term, fixed-rate funding Participation requires specialized underwriting and legal expertise and relationships with agents and issuers; as an alternative, investors can develop an association with a firm providing those capabilities private, and stock buyback and recapitalization programs. Higher returns attract private bond investors. Yields can be basis points greater than comparably rated public bonds. Private bond holders typically have more robust rights through covenant protections. Private bond covenants often limit the ability of other creditors to be in a more senior position. The tradeoff for higher yield and better protection is lower liquidity. Private bonds are not publicly registered, can only be purchased for investment as opposed to resale, and can only be sold in private transactions to accredited investors. The United States private market is unique. In 2012, more than $54 billion in private bonds were issued in the U.S. in more than 200 deals, compared with $1 trillion in public bond issues. The average deal size was $256 million, and the largest was $2 billion. 2 1 Source: Bank of America. Period of 9/30/ /31/ Source: Bank of America/Merrill Lynch.
2 PAGE 2 Companies ranging from small, privately-held organizations to large multinational corporations use the private market. A major power company, an internationally-known automobile manufacturer, an international airport, a well-known food company and several major league sports franchises recently issued private bonds. High quality companies dominate the private market, giving investors an opportunity to diversify without sacrificing quality. General industrial, and energy and power companies each accounted for 32% of the issues in 2012, as the pie chart shows. Issuance is typically dominated by these two sectors. Non-U.S. issuers accounted for the majority of private bonds, following the historical trend. Domestic issuance remained the single largest geographic concentration, accounting for 44% of issuers in Private Bond Issuers, 2012 General Industrial 32% Energy & Power 32% Consumer & Retail 14% Media & Telecomm 6% Real Estate & Gaming 5% Tech/Bus Svcs 4% Financials 4% Healthcare 3% U.S. 44% Europe 38% Aus/NZ 10% Canada 6% Other 2% Source: Bank of America/Merrill Lynch. Debt Private Placements- Market Perspective, 1Q 2013 Recap. As the table shows, private bonds are typically investment-grade, predominantly NAIC 2 (BBB) 3 rated borrowers. % of Issues Rated NAIC 1 & NAIC 2, NAIC 1 34% 42% 35% 30% 37% NAIC 2 66% 58% 65% 70% 63% Source: Advantus, Private Placement Monitor. Why Issuers Access the Private Market Issuers turn to the private market for several reasons. They may wish to diversify credit sources. Some organizations prefer keeping financial and company information somewhat private. In some cases, the small size of an issue may rule out the public market. A company without a long credit history may also view the private market as a path to building a good reputation in preparation for future public bond market entry. Diversifying credit sources allows a company to choose between bank loans, private issues or public bonds to meet a particular funding need. Public bond issuers may maintain long-standing relationships with the private placement market to keep this channel open. During the 2008 financial crisis, the private placement market continued to function. Private bond issues do not require registration with the SEC or a rating from rating agencies. The company issuing a private bond must provide detailed information, but that information is shared with a limited group of potential investors. Approximately 5-20 investors purchase the typical private bond issue. This limited disclosure of financial information to investors can appeal to family-owned or closelycontrolled companies. Custom debt structures and terms are more readily accepted by the private market. Most private offerings 3 Each private bond purchased by a U.S. life insurer is annually assigned a risk-based capital rating by the Securities Valuation Office (SVO) of the National Association of Insurance Commissioners or given an equivalent designation based on a monitored Acceptable Rating Organization (ARO) per NAIC guidance.
3 PAGE 3 include multiple tranches with different maturity dates and interest rates. A $200 million private bond offering, for example, may consist of four separate $50 million tranches with maturities of 5, 7, 10 and 12 years. Private Investors: The few, the knowledgeable, the experienced The private bond investor universe is comprised of about 50 institutional firms. Investors consist largely of life insurance companies, followed by asset managers and pension plans in the United States and the United Kingdom. Most of these firms have a lengthy private bond history, although new investors have recently shown increased interest. One option for new investors to the private bond market is working in association with an experienced private bond advisory firm. Investors value higher yields, a level of credit quality comparable to the public market and the opportunity for pre-purchase due diligence found in private bonds. Private bond holders can also build relationships with management at the time of the deal and maintain those relationships after purchase, which can be important if covenants come into play. The private market offers investors diversification through a multitude of companies that issue private debt. The international origins of many issuers offer a further diversification opportunity. Insurance companies also value the ability to match their liabilities with the typically longer private bond maturities. Purchasing a private bond is a legally intensive process. Investors must have the credit underwriting expertise to price private bonds and the legal skills and experience to evaluate deal terms and covenants. The Note Purchase Agreement (NPA) contains negotiated terms and conditions, including covenants. The NPA also typically defines default events (failure to make timely payments, breach of covenants, etc.), outlines default remedies and includes call protection terms (T+50 make-whole is market standard). Covenants Differentiate Private and Public Issues Covenants are a key differentiator between public and private bonds. They govern the relationship between the private bond issuer and the investor, protecting the bond holder. Skillful covenant evaluation when buying bonds can mitigate an investor s losses and improve recoveries in a default scenario. Covenants legally compel management to maintain key financial metrics. Examples include limits on debt relative to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), restrictions on asset sales, and requirements to maintain minimum coverage ratios. Covenant violations can trigger default and/ or compensation to bond holders through waiver or amendment fees, coupon bumps and prepayment premiums. Private bond holders regularly receive financial information from the issuers. Issuers provide quarterly or semiannual financial statements and covenant compliance certificates. They also must notify bond holders of default events and respond to bond holder requests for additional information, or provide access to management. Covenants may result in renegotiation with bondholders or provide an exit route if the company is struggling to comply with the covenants. Investors must represent at the time of purchase that they plan to hold private bonds to maturity but there is a limited secondary sale market available. Sometimes bond issuers themselves repurchase their own private bonds before maturity, either at their option pursuant to prepayment provisions or as required pursuant to change in control provisions that may be in the private bond terms. Where Diligence and Time are Demanded Diligence is the price of admission to the private market. The responsibility for underwriting private credit risk falls on the buyer. Buyers must independently analyze and price credit risk. They also need considerable legal expertise.
4 PAGE 4 Relationships are also important in this market. Successful private placement buyers form strong connections with issuers, placement agents and legal advisors. They also participate in the market frequently enough and hold a private bond portfolio with sufficient scale to make their investment in credit underwriting, legal and back office infrastructure pay off. portfolio takes time. Investors must be selective and attentive once the investment is part of their portfolio. Proactive credit monitoring, ongoing reviews of covenant compliance, and periodic valuation analysis are necessary exercises in maintaining a healthy private portfolio. Successful private programs are built on the knowledge that not all private bonds are created equal, and that strong covenants alone do not justify investing in a weak company. Creating a strong private bond Specialized Maintenance and Ongoing Due Diligence Enhance Portfolio Value
5 PAGE 5 Comparing Public Bonds, Private Bonds and Bank Loans Public Corporate Bonds Private Placement Bonds Bank Loans Credit Quality Investment-grade Investment-grade High yield Security Unsecured Initially unsecured with Secured limitation on priority debt Covenants None/limited Typically parallel banks, may Comprehensive be less restrictive Rate Fixed Fixed Variable Rate Adjustments None If negotiated for covenant breach Spread set according to leverage grid Maturity Full spectrum Intermediate to long 3-8 years Prepayment Non-call or make-whole Non-call or make-whole Pre-payable at par provision provision Liquidity Registered Unregistered Unregistered Investor Base Broad Narrow; largely insurance companies Increasingly broad; institutional investors and funds, banks Summary The U.S. private bond market for decades has provided borrowers across the globe with customized term funding solutions. Investors have earned higher returns through improved yields and fee income, increased diversification and strong investor protection. It takes an experienced hand to successfully tap the benefits of the private market. Investors can find that experience by working with an asset manager who has specific private placement underwriting and legal expertise, and solid private market relationships. At a time when the search for yield is so intense, investors owe it to themselves to look closely at the private placement market. Advantus Capital Management has successfully managed private placement portfolios for over 40 years. We select private bonds through a disciplined, rigorous process. Our dedicated underwriting, surveillance and servicing teams create strong income-producing portfolios for our clients. Benefit from private placement bonds: basis points of additional yield over comparable public bonds Diversification with high quality companies not available in the public market Robust provisions that protect investors and, if the unintended happens, potential to renegotiate terms and/or receive compensation
6 PAGE 6 For more information, contact: Julie Gerend, Sr. Vice President Business Development & Client Service julie.gerend@advantuscapital.com Steve Moen, Vice President Business Development steven.moen@advantuscapital.com This document is directed at institutional investors and consultants. It should not be distributed to or relied on by retail investors. This document may not be reproduced or circulated without prior written permission from Advantus. No statements or representations made in this presentation are legally binding on Advantus. Unless otherwise stated, all views, projections and opinions are those of the authors as of the date of this document and are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which fluctuate. The value of investments and the income from them can go down as well as up and an investor may not get back the amount invested. Past performance is not a guide to what might happen in the future. This is not intended as a recommendation, offer or solicitation for the purchase or sale of any financial instrument. 400 Robert Street North, St. Paul, MN F IM A Advantus Capital Management, Inc. All rights reserved.
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