When Welcome Break’s owners, Investcorp, offered to pay bondholders back at par, it marked the end of one of the most tortuous sagas in securitisation of the last few years. Tom Allchorne examines what happened and why it could have important implications for private equity.
In 1997, it all looked like a great idea; Investcorp launched a £321m four-tranche bond issue to partly refinance the £476m loan it needed to buy Welcome Break, the UK motorway service provider it bought from Granada. But this was no ordinary securitisation, this was a whole business securitisation. Nowadays these are reasonably common, there are estimated to have been at least 30 since 1997. But back then it was something special. In a 2000 report, UBS Warburg called it “the ultimate breakthrough . . . [it] brought the technique firmly into the mainstream of corporate finance.”
By February 2002, things began to take a turn for the worse. The late 1990s saw Motorway Service Areas (MSAs) undergo a long-awaited revamp. The big three, Roadchef, Moto and Welcome Break, spent the last few years of the last decade implementing big capital expenditure programmes to improve facilities, food etc.
In 1998 Welcome Break raised a further £55m, and in the same year spent £65.4m and £52.6m in 1999 as part of its capital expenditure programme. Yet despite this, there was no significant improvement in performance; EBITDA barely rose. This meant there was a real danger that if the economy continued to slide, the company would not be able to meets its debt obligations.
Michael Cox, director in European structured finance at Fitch, says: “The transaction was significantly underperforming original expectations. The company was cash constrained, and faced the prospect of the start of Class A1 amortisation in just two years’ time. We felt the risk was sufficient to justify a downgrade.”
In February 2002, in the first ever downgrade of a whole business securitisation, the three classes of senior notes went from A to BBB+ and the junior notes from BBB to BB, pushing them into the junk grade ranks. Many of the original investors sold their bonds. Fitch downgraded again in April the same year because, explains Cox: “As soon as the statutory accounts were published, we realised that their reported EBITDA had included one-off exceptional profits, and that they were therefore in a worse position than originally anticipated.” Class A went to BBB, Class B to BB-. By the time Fitch withdrew its ratings in June 2004 after a series of downgrades, the Class As were at B, the Class Bs at C. Standard & Poor’s rated them C and CCC, respectively.
The offers begin
In 2003 Investcorp decided it was time to restructure its debt and so began a series of proposals to noteholders, not all of which were technically an offer. The first was a proposal to undertake a sale and leaseback of some sites and repurchase some, not all, of the class A notes at 84% and the class Bs at 37.5% of par. This was subsequently increased to 92.5% and 42.5%, respectively. But it wasn’t quite as simple as that, as Cox reveals: “There was considerable anger among the Class A noteholders that they were being asked to take a discount to par when the Class B noteholders received cash. The transaction is structured so that the Class B notes should take a 100% loss before the Class A noteholders have to take a loss. It was partly rejected for this reason, but also because investors felt it did not offer full value and that they would be better off waiting until they could get hold of the assets and sell them.”
In February 2004 Investcorp made a fifth offer to the noteholders: Class As were to be paid at par, Class Bs at 55%. It also announced that Rotch Property Group was buying eight Welcome Break motorway service stations for £247.5m in a sale and leaseback deal. This, combined with new debt and equity funding, would be used to repay the bonds. It said it intended to pump £33m of equity into Welcome Break, adding to the £72m it invested in 1997 and the £10m last year.
Receivership threat
Investcorp said if this was rejected, it would force Welcome Break Finance, the loan-issuer vehicle, into receivership. This is unprecedented in securitisations where the SPV is supposed to be bankruptcy-remote and if bad times strike it is the parent company, in this case Welcome Break Group, which is placed into receivership.
“I think that, at the time, many investors actually felt this was approaching a fair price for the Class B notes,” says Cox. “Investcorp again seemed to be trying to see whether there was a market for investors taking the money rather than holding out for an uncertain administrative receivership and sale. It seems that this proposal was rejected principally because one investor, SISU Capital, had a blocking vote of more than 25%.”
“The rationale behind Investcorp threatening insolvency is actually unclear,” says Cox. “At the time, we felt it was because that would alter the voting requirements, removing SISU’s blocking vote. However, it seems that they were willing to offer par, so that was perhaps less of an issue. More significantly, perhaps, the issuer default meant that Spens payments on the fixed-rate Class A3 notes were not due, saving Investcorp approximately £25m in additional costs. There is no doubt the continued threats meant that there was more uncertainty and therefore, potentially, a greater propensity to accept a refinancing offer.”
Neville Kahn, the insolvency partner at Deloitte’s who was appointed administrative receiver, says: “What Investcorp planned to do was say to the class Bs: ‘if you don’t sell us your notes, we will take Welcome Break Finance into receivership’, thinking that the receivers would give the class As everything back and the class Bs would get less than 55%. Deloitte said this was rubbish as they would market the bonds and look at selling off the operating companies.”
In May, Fitch announced Welcome Break Finance had a ‘balance sheet deficit.’ On top of this was the possibility that if Welcome Break Group failed to make full payment on its loan from the supposed bankrupt-remote vehicle, it too could be put into administration. And then, on May 25, Welcome Break Finance did indeed go into receivership and a few days later Investcorp finally agreed to pay all classes of bondholders back at par. The paying in full of the £67m class B bondholders has added £30.2m to Investcorp’s costs. On June 2, Welcome Break sold nine service stations to Rotch for £270m. The company plans to lease back the highway cafes and shops.
On the plus side for the securitisation market, the Welcome Break saga is unlikely to be repeated. Firstly, there was the rather strange, yet accidental oversight in the financial arrangement in 1997, which failed to give the noteholders automatic recourse to the operating assets.
Secondly, it paid the price of being a pioneer. “It was a very early whole business securitisation, and the technology has come a long way since,” says Cox. “An amortisation holiday at the start of the deal, together with the need to grow to meet amortisation payments, are very important aspects of this transaction that do not feature on other whole business securitisations today. The company faced a ‘cliff’ of debt service, which it was clear that they couldn’t afford. A more likely scenario now is a gradual deterioration from healthy coverage, which would not cause the same problems for the deal. Having said that, it is inevitable that other deals will suffer from stressful periods. We don’t believe that they will go through the same process as Welcome Break, however.”
The drive to transparency
Of all the issues to be provoked by the Welcome Break saga, the biggest one for the private equity industry is transparency. “There was a definite frustration by noteholders over the lack of information made available to them by Investcorp,” says Kahn. “Investcorp was worried about strategic information being in the public domain but people like to see what is going on so they can make their own decisions.”
Private equity firms do not like transparency. As Dominic Crawley, European head of leveraged finance at Standard & Poor’s, puts it: “They like to control the flow of information to the market.”
This was particularly true of Investcorp. “The reporting for the Welcome Break transaction in the early years was very poor indeed,” says Cox. “It did improve, but key elements of performance were not made clear in the reports sent to bondholders. One example is the exceptional items unveiled by Fitch: until we downgraded and published our report in April 2002, investors thought that the company was generating £7.8m more cash each year than was actually the case. Quite whether this was a case of not wanting people to know the true extent of the difficulties they were facing, or a case of private equity firms not being transparent is a matter for debate.”
Crawley says: “By and large, private equity funds do not like the transparency of credit benchmarking that ratings provide. However, for some LBO financing structures, corporate securitisations for example, the market requires ratings. Whilst such ratings should be subject to less volatility than more traditional counterparty default ratings, they will be adjusted to reflect underlying operating performance and any downgrade will be unwelcome news to the financial sponsor.”
An additional reason is that ratings are simply a pain for private equity managers. It’s another distraction from doing the deal, and introduces uncertainty into the mix. If a company gets poor ratings, it becomes harder to do the deal.
The problem for private equity firms, though, is that the market is pushing for greater transparency, and the squeeze is coming from two sides. On one side there are the LPs: they want to know how the fund they are investing in is performing.
On the other side, there are the bondholders. In the US, 60% to 70% of senior secured debt sources comes from non-bank investors, and these want to know ratings. In Europe it used to be around 2% or 3%, but over the last few years it has risen to over 20%, and it is these non-bank investors that are driving the transparency argument. US funds are not particularly bothered by ratings, but certain European ones are very sensitive about it.
Kahn says: “When refinancing LBO debt using corporate securitisations, it is absolutely critical there is independent valuation for the stakeholders, otherwise they are reduced to making guesses.” Put simply, investors want to know exactly what they are getting for their money.
Unfortunately, and predictably, it isn’t quite this simple. “The noteholders are a very disparate bunch by their nature and the fact that notes change hands quite a lot means that it is difficult for the private equity guys,” says Kahn. And because bondholders change frequently, it means a GP could tell something to one about the issuer company only for that holder to then sell the stake and take that information with them. There is little or no chance/time for trust to build up between company owner and company investor, in contrast to the use of bank debt.
If a noteholder did sell a stake because of information given by a GP, this creates a whole new set of problems because of insider trading. This is yet another argument in favour of greater transparency; if company performance is public knowledge, there is no danger of breaking the law by selling or buying stakes.
Syndicators would also rather have a rating because it makes it easier to syndicate, but they are reluctant to push it too much because the private equity houses don’t like it and, in today’s competitive market, can easily find a syndicator that will proceed on a non-rated basis. The problem here is that if the firm itself doesn’t get a rating on its assets, an investor will ask a ratings agency to do one privately. A firm therefore seems to have two choices: to let an agency do a private rating and run the risk of getting a bad and inaccurate report on its assets, or engage in the process. Against this, however, the private equity house must balance the need to protect commercially sensitive information that could have the potential adversely to affect the eventual sale price of its investment, thereby jeopardising both its and its LPs’ returns on the investment.
Firms have already responded to the pressure, and many deals today include covenants outlining the sort of reporting they will provide. Investors and rating agencies are pushing for this to be included in the documentation. Cox says: “This reflects a maturing market, and not just the issues raised by Welcome Break.” There is a definite trend towards greater exposure; a pressure that will only increase over time, especially in those transactions which top half a billion.
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