Whole-business or operating-company securitization may be the latest fad in structured finance, but there is nothing new about the concept. Since the mid-1990s, specialist buy-out firms such as Nomura’s Principal Finance Group have financed their purchases of pub estates and train rolling-stock companies by pledging all the cashflows from these businesses to bondholders.
What is new about the latest such deal is the type of business being securitized. At the end of February, JP Morgan closed a deal that partly refinanced Doughty Hanson’s acquisition of food company Ranks Hovis McDougall (RHM).
The private-equity firm bought RHM from UK conglomerate Tomkins last July for £1.1 billion.
RHM Finance issued £650 million-worth of bonds rated between triple B and single B. The notes were secured by cashflows from a business comprising several of the UK’s best known brands. They include such old favourites as Hovis bread and Bisto gravy powder. There are also rising stars of the food world such as Sharwood curry sauces. Another illustrious member of the portfolio is Mr Kipling cakes.
This line of sticky buns is known to every UK consumer for being – as their slogan puts it – exceedingly good cakes.
Most private-equity sponsored buy-outs are financed with high-yield bonds, mezzanine loans, leveraged loans – or a combination of all three. But as appetite for high-yield credit risk collapsed last year, the company and its new owners were forced to look around for an alternative source of financing.
Given the difficult circumstances, the securitization can hardly be described as an exceedingly good deal. But it kept RHM’s debt costs down. RHM was looking to borrow some four times its earnings. During the bumper days of European leveraged finance in early 1999, it might have had to pay coupons of 9% or so on a straight high-yield bond issue.
Since then, high yield spreads have moved out by some 200 basis points, suggesting the company would have to offer coupons well in excess of 11% today – if it could issue at all.
By comparison, the coupons on RHM’s asset-backed bonds, a mix of fixed rate and floating, amount to around 9.5% at today’s interest rates. However, what RHM saves in interest payments it loses in flexibility, since securitization places constraints on the company’s managers. What’s more, the nature of RHM’s business means this was an exceedingly complex deal.
There is one crucial difference between RHM’s business and that of other companies that have been securitized. RHM’s most important assets are not property but brands. “Pub securitizations rely heavily on the property component,” says Gavin Alexander, vice-president in JP Morgan’s structured finance division in London. “For tenanted pubs, in particular, whole-business securitization is relatively straightforward. There are easily definable cashflows and the company typically borrows 75% or 80% of the value of the property. RHM, by comparison, is a large, actively-managed operating company.”
As a result, getting the bonds rated was not straightforward. “Because this business has a limited asset base, the ratings are based more on underlying business fundamentals than is usually the case with a securitization having a substantial property-related asset base,” says Adam Toft, senior vice-president in Moody’s structured finance division in London.
In other words, RHM’s bonds are backed by the sheer branding power. “RHM is part and parcel of the grocery trolley of everyone in the UK,” says Alexander. “Its brands are all number one or number two in their categories. That provides much stability for the business.”
But this doesn’t mean that any company with strong brands can use them to issue relatively cheap debt. “There are limits to the kinds of businesses that can be securitized in this way,” says Toft at Moody’s. “We know this financing tool works for the pub sector.
Perhaps it may be extended to regulated or quasi-regulated businesses with stable cashflows. But it remains to be seen whether deals can be done beyond those areas.”
Two things make RHM suitable for whole-business securitization. First, it enjoys an entrenched position in its chosen markets.
Food is a volume game, with low margins and high barriers to entry. Any competitor would need to spend heavily to build its own rival brands and distribution network. In addition, RHM owns some property, and this helped it to secure the all-important credit ratings.
Consumer brand marketers in countries other than the UK would not be able to do deals using the same structure as RHM. One reason most whole-business securitizations have so far been done in the UK is that English law gives structurers a unique tool to secure cashflows in the bondholders’ interests.
Under UK insolvency law, a creditor can be given a charge over certain of a company’s assets or cashflows. In RHM’s case, the bondholders have a charge over the company’s branded-goods businesses, including three special purpose companies that own the intellectual property – that is, the rights to the brands. Granting this legal charge saves the borrower from having to sell the assets to the issuing vehicle.
One of the biggest challenges facing the deal’s arrangers was that not all of RHM consists of consumer brands. The company also supplies products to large, individual customers such as fast food restaurant Pizza Hut and retailer Marks&Spencer. These divisions lack the stable cashflows of the consumer divisions: if Pizza Hut decides to cancel its contract, that business is in big trouble.
Eventually, after lengthy negotiations between the rating agency and the bankers, it was decided to leave these non-consumer businesses out of the deal altogether. Instead of being securitized, these divisions would be financed with a bank loan. This decision added to the workload. The arrangers then had to split RHM into two separate entities and draw up separate accounts for each of them dating back five years.
A small army of lawyers went to work on the deal, with Allen&Overy advising JP Morgan and Lovells advising RHM and Doughty Hanson. Lovells fielded partners expert in capital markets, corporate issues, banking, intellectual property, pensions, tax and property issues.
RHM’s five consumer divisions are ring-fenced by the legal charge. In addition, bondholders are protected by covenants that prevent the company from selling certain assets and giving too much cash to shareholders.
Fees on the transaction have not been disclosed. But such deals don’t come cheap. The complexity of the structure, the lengthy process of obtaining a credit rating and the cost of setting up several special purpose companies will have all contributed to an expensive structure.
All in all, did securitization provide a clear benefit over plain vanilla debt?
Alexander thinks it did. “The normal way to refinance an acquisition like this would have been through a high-yield bond issue,” he says. “That was not realistic at the time because the high-yield market was effectively closed. But even if conditions had been better, a deal of this size would have needed to be done in dollars and euros.
Securitization allowed us to refinance a business with 95% of its revenues from the UK without a currency mismatch.”
Several investment banks are keen to develop securitization as another tool in their acquisition finance armoury. But RHM’s deal suggests that whole-business securitizations require highly complex structures and protracted negotiations with the ratings agencies. Unless securitization bankers can come up with some simpler templates, the high-yield market may beat them hands down when sentiment improves.
