These ESG factors can be applied to most investment grade credit issuers, as these they are often listed companies and must disclose this information.
But many issuers are private and, as such, these considerations are not relevant. A company could be 100% owned by a private equity firm, which controls the board and thus the direction of the business. Little consideration is given to ‘independent’ views. In some cases, this is not problematic and the interests of all stakeholders – equity and credit alike – are aligned.
For example, the private-equity owners and management of global facility services company ISS believed deleveraging was the best way to de-risk the company ahead of its successful IPO in March 2014 – which, in turn, was a deleveraging event. The once junk-rated company is now rated investment grade and is an example of the benefits of an alignment of interests for both shareholders and creditors.
In the US, Intelsat, a highly leveraged satellite services company, has sent a very clear message it sees deleveraging as the best way to create value for shareholders. Having already paid, down debt with proceeds from an IPO, it continues to reduce debt and refinance at lower interest rates, thus reducing its risk profile. This has rendered the spreads of the generously levered, low-rated company to perform in-line with, if not better than, the broader market.
In other cases, however, shareholder actions are antithetical to the interests of lenders. The recent collapse of UK retailer Phones4U is an example of the highly destructive impact aggressive owners can have on a business. Would an independent board have decided to issue a £205m holding company PIK note to help finance a £225m dividend to shareholders? Given the elevated operating risks the company was facing amid structural change in both the retail and mobile device markets, it is unlikely. Consequently, the company’s financial risks would have likely continued to decline rather than suddenly intensify as it entered tough negotiations with Vodafone, a key customer.
While a PIK-dividend deal is not villainous in itself, a re-leveraging event needs to be considered in the context of the overall business and financial risks. Phones4U could have chosen to simply use excess cash on its balance sheet, generated from an asset sale, to redeem some of its 9.5% 2018 bonds, enabling it to refinance the entire issue at a lower rate. This would have reduced cash debt-service costs and thus the financial risks for a company struggling to grow.
In contrast, the business risks of US firm Neiman Marcus Group (NMG) were moderated by its steady growth and skilful execution. In March 2012, NMG financed a $443m dividend using cash on its balance sheet and borrowings. Three months earlier, the spread on NMG’s five-year credit default swap was about 580bps, compared to the 680bps of the index. At the time of the announcement, which some market participants expected, NMG’s CDS spread widened 50bps only to revert close to its previous level. Remarkably, it ended the year at 280bps, compared with the index’s 495bps. Despite the re-leveraging event, NMG had significantly outperformed. Since then, the company filed a prospectus for an IPO, but ended up being sold to another a private equity group.
These episodes highlight the imperative to consider ESG factors as part of a broader set of corporate risks. They show fund managers should not take a dogmatic approach to such credit-negative events. Instead, we must analyse them in the context of the financial strength of the business itself.