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It’s Still Time to Restrict the Abuse of Unrestricted Subsidiaries

By Jacob Wolinsky. Originally published at ValueWalk.

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Back in 2019, Xtract Research wrote about Unrestricted Subsidiaries and how the ability to capitalize them and use them for purposes detrimental to investors needed to be reined in.


Q4 2020 hedge fund letters, conferences and more

Two years later, not only has nothing changed, but both bonds and loans are just as permissive and, in some cases, pushing the envelope even further than before.

In a new report, Xtract Research provides a refresher.

Restricting the Abuse of Unrestricted Subsidiaries

Highlights from the report include:

Diamond Sports has for months been the subject of speculation that it could drop an asset into an Unrestricted Subsidiary. More recently we have received inquiries about private prison operator Geo Group’s ability to move assets to Unrestricted Subsidiaries in light of its upcoming maturities and a number financing institutions (including some of its existing lenders) unwilling to lend to companies that operate secure services facilities and centers pursuant to public-private partnerships.

J.Crew’s credit agreement made famous the so-called “trap door,” permitting any investment made in a nonguarantor restricted subsidiary (step one) to be further invested in anything, including an Unrestricted Subsidiary (step two). While step one was capped in J.Crew’s Credit Agreement since many loans now adopt the bond style investment regime for investments within the restricted group, loans (and bonds) that include step two create a bottomless black pit for value leakage. We still only see this provision infrequently, but it is typically pretty easy to spot within the Permitted Investment exceptions. We have, however, seen it buried at the end of the definition of “Investments” in Radiate Holding’s Notes issued last year (but it was removed pre-pricing).

Triton’s recent bonds include two variations on this provision that at first glance may look ok but in reality, are not. One expressly excludes usage for investments in Unrestricted Subsidiaries, but it is still a back door way to move value to shareholders. The other is different story.

Leverage neutral incurrence tests for debt are not new. In both bonds and loans, debt incurred to make investments/acquisitions is often permitted under leverage or coverage tests if a specified test is met or the ratio is no worse pro forma for the transaction. This is sensible, as an acquisition will grow EBITDA. Trying to use leverage neutral incurrence tests for investments is not new either. However, unlike their usage in acquisition debt, they do not make sense in the investment context.

The post It’s Still Time to Restrict the Abuse of Unrestricted Subsidiaries appeared first on ValueWalk.

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