Investors may demand better terms in special mandatory redemption clauses amid longer deal review times and rate cut risk.
Treasury teams structuring bond deals to fund M&A transactions who want to lock in rates before an acquisition closes may need to sweeten the terms of a clause in bond offerings called a special mandatory redemption. The key reason: increased risks for investors stemming from longer regulatory reviews of mergers and the possibility that deals fall apart.
- SMRs typically require an issuer to repurchase the bonds at a premium—typically 101% of par—if the deal is not completed within a specified period, traditionally one year.
- SMRs help corporates entice investors who are exposed to interest rate risk if the deal falls through. The clauses also give companies increased financing flexibility.
Regulators and rates. More scrutiny of M&A deals and longer periods to review them by US regulators, as well as a possible recession and the specter of falling interest rates, may drive more investors to push for changes in SMR terms in the months ahead, according to NeuGroup members and bankers who work with issuers.
- At a session of NeuGroup for Capital Markets sponsored by Deutsche Bank, Ryan Montgomery, a managing director in liability management at the bank, spoke about the shifting state of M&A financing and what steps corporates should be prepared to take to draw in investors if market and economic conditions shift.
- “Investor willingness can change,” Mr. Montgomery said. “If you’re contemplating M&A and you might not be funding it until sometime in 2024, you have to be prepared that the environment might not be as easy to obtain these types of provisions. So the question is, how can companies adapt to continue to get the flexibility they need?”
Higher premiums. In addition to M&A deals taking longer to complete under the Biden administration, SMRs are coming into focus now because of the possible effects of falling interest rates that would likely come with a recession. In that scenario, investors holding SMR bonds issued when rates were still high will likely see them trade at a premium as rates fall and bond prices rise. No problem there.
- But if the acquisition is delayed by regulators past the SMR date (triggering the SMR clause), investors would lose their mark-to-market gains and receive only the 1% premium for a bond trading above that in the secondary market. And they would be reinvesting at lower rates.
- To ensure the bonds remain attractive to investors, some corporates are considering raising the premium paid if the SMR clause is triggered. One member in another session has weighed raising the premium two or three points above par. However, he expressed concern this would signal a heightened risk of the deal not closing.
The synthetic route. Another way to improve SMR terms for investors is pricing bonds at a discount to par, which one member called raising the premium synthetically.
- One complication with the synthetic approach is that by pricing the bonds at a discount, the corporate receives less cash from the bond issuance, potentially creating the need to raise the size of the deal.
- “As the discount gets larger, it could start to add up. For example, an average of five points on a $10 billion deal would be another $500 million of funding,” Mr. Montgomery said.
Step right up? In response to longer regulatory reviews of deals, some corporates, including one NeuGroup member, have extended the terms of an SMR clause to 16-24 months to give themselves more negotiating time and maneuverability. But this creates more time when market conditions could move against investors who buy the bonds.
- If investors begin to push back on these longer time horizons for a standard 101% redemption, Mr. Montgomery suggested issuers “consider including SMR pricing that steps up to something like 102% after 12 months and maybe more after 18 or 24 months.”
Investor activism. This year, The Canadian Bond Investors Association and The Credit Roundtable have advocated for changes in SMR provisions. Their proposals include requiring that at least two-thirds of bondholders support changes to SMR terms—including the time-period in which the deal must be completed.
- Perhaps the most significant proposal is setting the redemption price at the greater of a) a price based on a predetermined percentage of the original offer spread and b) a pre-set percentage of par, such as 101%. That change would expose the corporate to interest rate risk.
- Mr. Montgomery does not expect issuers to be willing to bear this risk. “The whole reason SMRs exist is that issuers want to get large-scale financing done and be able to lock in interest rates,” he said.
- “If the acquisition goes away, they are willing to pay the extra point for insurance. If corporates had to bear the full exposure to interest rate moves in the event of a busted deal, they would probably simply not do the M&A financing ahead of closing.”
Prepare for a bear. A deeper than expected recession could send corporate bond spreads wider as investors demand more yield in response to weaker earnings and lower cash flows. That would also likely prompt investors to demand changes in SMR terms. “Investors aren’t yet pulling out of fixed income markets, but a bearish credit market could come, and investors could collectively push back enough to get a big change,” Mr. Montgomery said.
- “We think issuers should prepare for this possibility so that if markets turn for the worse, they are ready with SMR terms that respond to investor concerns in a way that balances issuer and investor interests.
- “While changes may not be necessary in a strong market environment, we don’t want to see issuers caught flat-footed if the market for jumbo M&A offerings becomes more challenging from when they announce their M&A deal until they launch the financing.”
