Even with strong covenants, Falcone's HC2 junk bond lingers

09 November 2018 | By Natalie Harrison

HC2 Holdings, a diversified holding company run by hedge fund manager Philip Falcone, is offering investors something they don’t see very often in the junk bond market - a new issue with some of the strongest buyside protections in years.

Yet the US$540m deal, rated Caa1/B-, is still not completed.

The bond was announced on October 22 and finished marketing on October 30. As of November 9, it still hadn’t priced.

One hurdle the deal has faced were very volatile stock markets. That bled into the US high-yield bond market, where three deals have been pulled in the last couple of weeks.

Another is the nature and complexity of HC2, a holdco structure that does not always appeal to investors.

It acquires businesses it believes are undervalued, or whose growth potential is significant and possibly underappreciated.

Operating subsidiaries include construction, marine services, energy, telecommunications, life sciences, broadcasting and insurance.

While that offers a diversity of income flows, some investors told IFR they were concerned those businesses did not complement each other.

“I’m not a fan of investing in heavily levered, acquisitive split CCC/B- holdco’s of a hodgepodge of businesses,” said one investor.

HC2 declined to comment. Jefferies, sole lead on the bond, also declined to comment.

ART OF THE COVENANT

Yet there are elements to the offering that should be very attractive to investors.

For one, participating bondbuyers will get an attractive yield. The maturity of the bond was shortened to a three-year non-call 1.5 from a five-year non-call two and hiked the price talk to a 12% yield from initial whispers of low-to-mid 9%.

They will also benefit from rare maintenance covenants.

Moody’s assigned a 1.57 covenant quality score to the bond this week, where on a scale of 1 to 5, 1 denotes the best bondholder protections.

“This is the strongest covenant score we have seen on a North American high-yield bond since March 2013,” Evan Friedman, an analyst at Moody’s, told IFR.

“The inclusion of maintenance covenants, and the number of them, makes this deal unique,” Freidman said. “But there are a number of other investor protections that rarely or never feature in high-yield bonds.”

Maintenance covenants are more often seen in loans rather than junk bonds, and are hardly even seen in loans these days. They require borrowers to meet certain financial tests over a specific period.

TIGHT LEASH

The company will have very little wiggle room to raise additional debt, pay dividends or move assets around after investors demanded the extra precautions.

The HC2 covenants mostly address investor concerns about the company’s ability to move assets out of creditors’ reach - which could potentially weaken the value of collateral - and its flexibility to increase leverage.

Typically, an issuer can incur more debt to finance dividends out of its accumulated restricted payments basket if it is not in default, and if its EBITDA is at least double that of its interest expense.

But there is no restricted payments income basket in the HC2 deal, and the company has limited ability to add more debt through the life of the bond.

It can only make restricted payments with carve-outs, which limits the company to extracting funds from a US$10m general basket, and a US$5m basket for employee stock redemptions, Moody’s said.

“Investors have spoken. They are not willing to entertain dividends at this company,” said Friedman.

In addition, investors have ensured that HC2 cannot designate any subsidiaries as unrestricted subsidiaries.

That means it will be unable to move assets out of the group and out of the hands of creditors, in a similar way that other companies like J. Crew have done in the past.

“Investors are making sure the collateral will continue to support the debt obligations. That covenant is a very nice get,” said Friedman.

Most high-yield bonds allow for some assets to be moved to unrestricted subsidiaries, and was a feature in the original HC2 bond terms before the investor pushback forced changes to be made.

Falcone became CEO of HC2 in May 2014.

As a co-founder of hedge fund Harbinger Capital Partners (HCP), he made billions betting on the subprime mortgage crisis. But he later suffered heavy losses after investing in wireless company LightSquared, which went bankrupt in 2012.

Falcone also agreed to a five-year industry ban from the securities industry in 2013 related to HCP - including for favoring some investors over others and borrowing US$113m to pay personal taxes.

“It is remarkable that Falcone, once a Titan in the credit markets, is struggling to get a deal done,” Mike Terwilliger, a portfolio manager at Resource Alts, told IFR.

Proceeds from the new issue will refinance a US$510m bond due to mature in December 2019 and that pays an 11% coupon, according to Refinitiv data. Some see the deal getting done, despite the hurdles, as soon as next week.