Corporate governance: Methodology
ARE BONDHOLDERS GETTING their due from efforts to improve corporate governance? “As corporate governance specialists, we don’t often look much at the interests of creditors,” says David Paterson, head of research at RREV, a provider of corporate governance services. Paterson’s rationale is simple, and reflects the consensus among his colleagues: corporate governance is there to ensure that shareholders, as owners of a company, are able to protect their interests against failings at management level. Furthermore, shareholders are the main bearers of risk, they stand to lose their assets if a company defaults since they are subordinated to creditors.
Paterson argues, though, that the interests of debt and equity are aligned a lot of the time. “Good corporate governance is in the interest of both bondholders and shareholders,” he says, “as the basic pressure exerted on the management is on improved accountability, which should be of value to all stakeholders.” Long-term investors especially are keen to ensure the long-term sustainability of a company, which includes a healthy balance sheet.
However, in the present liquid credit environment, companies are borrowing at record levels and event risk is increased through strong M&A and LBO activity. Shareholder activism, which is prominent since hedge funds are often equity owners, can also lead to restructurings, share buybacks and extra dividends at the cost of credit ratings. “We are at a time in the cycle when management is more concerned with shareholders than with bondholders,” says Ian Robinson, head of credit strategy at asset managers F&C.
John Bilardello, managing director at Standard & Poor’s, takes a similar view. “Due to the hyper-liquid environment, companies have been making increasing use of cheap access to loans and the debt capital markets to use the corporate balance sheet to the benefit of shareholders,” he says. “This environment puts pressure on credit quality.”
Such corporate initiatives often depend on added leverage. But often the companies that issue debt or take out loans are vulnerable. Even if share prices are boosted as a result of extra leverage, firms become more vulnerable to unforeseen events, such as a commodity price spike or the loss of a key customer, which can leave them facing a credit rating downgrade. Moody’s data shows that 46% of its fallen angel ratings in 2005 were the result of leveraged buyouts, mergers and share repurchases.
Prominent examples of rating decline abound. Both S&P and Moody’s have warned that the LBO of US hospital operator HCA, announced in July, will have serious implications for its credit ratings. With a total value of $33 billion, the LBO is the largest in US history. But this will not impress existing holders of debt, which will be more concerned by the prospect of a significant increase in leverage. Moody’s has stated that this could slash its ratings by several notches from Ba2 to the mid-single B ratings level; S&P has warned about the strong possibility of a one-notch decline from BB+. To make things worse, it is expected that part of the new debt will be senior to the current unsecured notes.
Similar concerns will have been raised by the announcement in September of a restructuring of Telecom Italia that will split the group’s mobile and network arms. As the perception in the market is that this move is a precursor to a private equity sale, trading in credit default swaps, which provides a quasi-insurance against non-payment of corporate debt, shot up immediately after the announcement. The holders of existing debt have reason to be anxious. “No one believes that there is any sort of protection for bondholders,” says F&C’s Robinson.
Of course, many of the downgrades are driven by LBOs initiated by private equity houses, an investor type to which corporate governance is irrelevant. Moody’s estimates that private equity transactions rose by 18% between 2004 and 2005. And corporate governance analysts point out that restructuring and leveraging up of a company does not belong in their realm. “I am not sure that these are corporate governance issues,” says RREV’s Paterson. “Corporate governance is principally about the quality of the board, and the responsibility of the board towards shareholders.”
Others are less convinced about this separation. “The inability [of a company] to meet its debt obligation is not good for shareholder value, as share prices drop. Share prices and credit spreads are quite heavily correlated,” says Ann Iveson, an independent debt advisory consultant. A fall in credit ratings also implies a rise in the costs of refinancing. And not taking into account interests of stakeholders other than shareholders, such as creditors, can be deleterious to a company’s long-term performance. Referring to a recent high-profile clash of interest between owners of equity and bondholders, the demerger of GUS into the Argos Retail Group and Experian, Iveson wonders whether it is wise to anger bondholders. “It is a question of when you apply the measurements,” she says. Now it appears that shareholders are gaining. But what if one of the entities wants to refinance in a year’s time, potentially the cost of capital will be higher. If buyers of debt become dissatisfied with the way they are treated by issuers, they might find that their cost of borrowing increases in the future.”
The stand-off between GUS and some of its bondholders is a complicated affair, with the company claiming that it is being held to ransom by a group of anonymous, opportunist investors that have bought into the company’s long-dated bonds. David Tyler, finance director at GUS, does not believe that the credit profile of Experian will be any worse than it was before the merger. The company’s offer to redeem the bonds at par is regarded as reasonable by many in the debt markets, even if it preceded a negative rating event.
Although it seems unlikely that a demerged GUS will suffer from the wrath of typical bond investors, the current level of liquidity makes it difficult for these investors to shun any issuer, even if he has previously disregarded their interests. “At the turn of the decade, bondholders had to be kept happy, which looked like good corporate governance, but now spreads are tight, one wonders how much they are concerned,” says F&C’s Robinson. However, things might change when the cycle turns and the investors can allow themselves to be more picky.
So are holders of corporate debt out of the corporate governance loop until the cycle turns again? Not quite. The GUS stand-off highlights two things: first, that a direct conflict of interest between bondholders and shareholders arises when companies restructure or alter their balance sheets; second, that the greatest threat to creditors, the private equity LBO, can be mitigated. In order to persuade bondholders to waive their right to define the demerger as a default event, GUS threw in a change-of-control covenant with the one-off fee. The covenant is set to assuage fears about a possible private equity takeover of Experian, the entity to which existing debt is transferred.
Change-of-control clauses in covenants have become standard in debt issuance, and help keep down the cost of borrowing. However, they are not without drawbacks for shareholders. “If they are in place to lower the cost of borrowing, they are in the interest of shareholders. However, that has to be weighted against the fact that they raise the cost of a takeover,” says William Claxton-Smith, head of corporate governance at Insight Investment. Change-of-control covenants can stand in the way of the healthy profits that a shareholder can expect when he sells shares in the process.
Peter Montagnon, director of investment affairs at the Association of British Insurers, and a member of the board of governors at the International Corporate Governance Network, goes as far as to liken them to a poison pill with a toxic effect on corporate governance: “The issue with change-of-control clauses is that they can be akin to a poison pill, and as such entrench the management at the expense of shareholders,” he says. Montagnon feels that “the debt market needs sufficient comfort, with protection given, or the risk at least being clearly spelt out. It is not fair that bondholders are forced to run risks without covenants.”
Whether the desire for cheap debt outweighs the potential downside of covenants in the event of a takeover in the mind of shareholders, or whether the bulk of investors that take their corporate governance obligations seriously adhere to the principle of not micro-managing the companies they hold equity in, shareholders have not been active in putting a hold on this trend. “My sense is that the market is beginning to recognize the need for change-of-control covenants, shareholders recognize the position of bondholders, and that they do not particularly object,” says Montagnon.
While market conditions favour holders of equity in a discipline that is designed to protect their interests above all others in the first place, bondholders are at least offered some protection. Unfortunately, it seems that even that goes against the basic principles of corporate governance: to ensure that the interests of management are not strengthened vis-à-vis those of shareholders.
