A Pragmatist’s Guide to Leveraged Finance Credit Analysis for Bonds and Bank Debt Robert S. Kricheff 2 Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jim Boyd Editorial Assistant: Pamela Boland Operations Specialist: Jodi Kemper Senior Marketing Manager: Julie Phifer Assistant Marketing Manager: Megan Graue Cover Designer: Alan Clements Managing Editor: Kristy Hart Project Editor: Anne Goebel Copy Editor: Gayle Johnson Proofreader: Debbie Williams Senior Indexer: Cheryl Lenser Compositor: Nonie Ratcliff Manufacturing Buyer: Dan Uhrig © 2012 by Robert S. Kricheff Publishing as FT Press Upper Saddle River, New Jersey 07458 This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by publishing this book. Each individual situation is unique. 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Printed in the United States of America First Printing March 2012 ISBN-10: 0-13-285523-2 ISBN-13: 978-0-13-285523-5 Pearson Education LTD. Pearson Education Australia PTY, Limited Pearson Education Singapore, Pte. Ltd. 3 Pearson Education Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educatión de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data: Kricheff, Robert, 1963- A pragmatist’s guide to leveraged finance : credit analysis for bonds and bank debt / Robert Kricheff. -- 1st ed. p. cm. ISBN 978-0-13-285523-5 (hardcover : alk. paper) 1. Financial leverage. 2. Securities. I. Title. HG4521.K7375 2012 332.63’23--dc23 2011049988 4 I would like to dedicate this book, with love, to my wife and my parents, all of whom I am blessed to have. 5 Contents Chapter 1 Introduction Chapter 2 Common Leveraged Finance Terms General Terms Yield and Spread Definitions Questions Chapter 3 Defining the Market and the Ratings Agencies Chapter 4 The Participants The Issuers The Sell Side The Buy Side Private Equity Chapter 5 Why Is Leveraged Finance Analysis Unique? Chapter 6 The Major Components of Analysis The Components A Pragmatic Point on the Various Aspects of Analysis Chapter 7 Some Features of Bank Loans Questions Chapter 8 A Primer on Prices, Yields, and Spreads The Basics A Few Points on Yields A Few Points on Spreads Bank Loan Coupons Duration Total Returns Deferred Payment Bonds: Prices and Yields A Pragmatic Point on Terminology Questions Chapter 9 A Primer on Key Points of Financial Statement Analysis EBITDA Capital Expenditures Interest Expenses 6 Taxes Changes in Working Capital Free Cash Flow The Balance Sheet A Pragmatic Point on Financial Statements Questions Chapter 10 Credit Ratios EBITDA/Interest Ratio Debt/EBITDA A Pragmatic Point on the Leverage Ratio A Pragmatic Point on Valuations Free Cash Flow Ratios Changes in Working Capital Dividends Acquisitions One-Time Charges The FCF/Debt Ratio A Pragmatic Point on Free Cash Flow Questions Chapter 11 Business Trend Analysis and Operational Ratios Business Trends Margins and Expenses Capital Expenditures Questions Chapter 12 Expectations, Modeling, and Scenarios Sales and Revenue A Full Model Scenarios A Pragmatic Point on Bank Maintenance Covenants and Expectations Questions Chapter 13 Structural Issues: Coupons Loan Coupons Bond Coupons Zero and Zero-Step Coupons How the Coupon Is Determined 7 Modeling Changes in Coupons Questions Chapter 14 Structural Issues: Maturities, Calls, and Puts Maturities Calls Clawback 10% Call Cash Flow Sweeps AHYDO Other Bank Prepayments Open-Market Repurchases A Pragmatic Point on Early Refinancing of Debt Questions Chapter 15 Structural Issues: Ranking of Debt Ranking Structural Subordination Subsidiary Guarantees Questions Chapter 16 Key Leveraged Finance Covenants Debt Incurrence Defined Terms and Carve-outs Defined Term Examples Carve-outs Restricted Payments Change of Control Asset Sale Reporting Requirements Other Covenants Affirmative/Maintenance Covenants Restricted and Unrestricted Groups Questions Chapter 17 Amendments, Waivers, and Consents Questions Chapter 18 Making Money or Losing It Off of News Events 8 Scenario: An Issuer Makes an Acquisition FastFoodCo (FFC) Facts GoodFoodCo (GFC) Facts Deal Facts Scenario: The Issuer Gets Bought Scenario: An Issuer Announces an IPO Scenario: An Issuer Is Facing a Maturity A Pragmatic Point on the Blended Price to Retire Debt Questions Chapter 19 Management and Ownership Chapter 20 I’m Looking at Debt, So Why Does Equity Matter? Valuation Monitoring Equities Questions Chapter 21 Value, Relative Value, and Comparable Analysis Questions Chapter 22 New Issuance Chapter 23 Distressed Credits, Bankruptcy, and Distressed Exchanges Claims Classes of Claims Subordination Claims Arising from Bankruptcy Valuing the Enterprise Sale or Restructuring Restructuring Without Bankruptcy A Few Pragmatic Points on Bankruptcy Reorganizations Questions Chapter 24 Preparing a Credit Snapshot Chapter 25 The Investment Decision Process A Sample Investment Process Big-Picture Items The Company Credit Fundamentals Event Analysis 9 Security Analysis Relative Value and Return The Decision Some Investment Traps Chapter 26 Closing Comments Answers Index 10