By Jacob Wolinsky. Originally published at ValueWalk.
One question that we frequently get asked these days is whether a particular provision, or a bond or loan agreement in general, allows a company to “do a J Crew?”
Q1 2021 hedge fund letters, conferences and more
How J Crew Moved Value Away From Lenders
In a new report, Xtract Research looks at how J Crew and other companies have used weaknesses in their covenants to move value away from lenders and bondholders.
Highlights from the report include:
There are lots of ways for a company to move assets out of the restricted group, and so it’s important not to focus just on baskets dedicated to unrestricted subsidiaries. J Crew had to resort to their tricky two-step process because they had exhausted all their capacity under the usual baskets and so had to get creative. But investors worried about asset stripping or value leakage should be looking at aggregate restricted payment and permitted payment capacity rather than focusing on one or two baskets in particular.
In principle, the biggest hole through which value can escape is the restricted payment “build-up basket” based on 50% of consolidated net income generated since the issue date. However, if it’s potentially the biggest source of value leakage, it’s also the least controversial, since it’s in pretty much every high yield bond and because payments from the build-up basket have to be “earned” out of 50% of consolidated net income generated after the issue date.
After the build-up basket, the biggest suspects for value leakage are any leverage-based restricted payment or permitted investment baskets.
In response to investor concerns, some companies have included “J Crew blockers” in their covenants which purport to limit the ability to move IP and other assets into unrestricted subs. However, these blockers are rarely completely effective.
There’s almost always some capacity to move cash and assets out of the restricted group. The question they really should be asking is how much can be moved.
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