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Investment Banking: What Happens to Bondholders in Mergers and Acquisitions?

In investment banking, there may come a time when bondholders of a company are affected by a merger or acquisition (whether your company was the one that bought another company or was bought). Unfortunately, there is no consistency to how you will be affected. Sometimes the bondholders are positively affected; other times, their positioned is greatly weakened.

The key motivation behind any merger is the concept of synergy — the two companies combined are worth more than the two companies operating separately. In essence, 1 + 1 = 3. Theoretically, if true synergies can be realized, and if the bondholders’ position in line either remains the same or is enhanced, bondholders should welcome the merger or acquisition.

The mantra of corporate management is to “maximize shareholder value” — after all, the shareholders own the company. But who’s looking out for the bondholder and ensuring that his needs are being addressed? Really the only line of defense for bondholders is what is spelled out in the indenture. A bond trustee is responsible for enforcing the provisions of the indenture.

With respect to mergers and acquisitions, several types of covenants safeguard the interests of bondholders and protect against actions that could enrich shareholders at the expense of bondholders. The goal of bond covenants is to place some restrictions upon management to limit risk-taking behavior to an appropriate level.

In the absence of these types of restrictions, you would see management taking on higher levels of debt and engaging in riskier strategies that have large payoffs if successful. After all, management compensation is often tied to the value of the equity through stock options and other incentive plans.

The idea of increasing leverage is akin to the old line “Heads, I win; tails, you lose.” In this context, management and shareholders are the “I” and bondholders are the “you.” Betting with other people’s money is good work if you can get it.

Common covenants include the following:

  • Debt covenant: A debt covenant limits the amount of additional borrowings of the bond issuer. These limits are generally some multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA).

  • Mergers covenant: A mergers covenant is designed to ensure that the bond debt and the assets that support the debt remain with the same organization. If the issuer of the bond merges with another company, then the bond obligation must remain with the merged company.

  • Change-of-control covenant: The change-of-control covenant is quite powerful and allows the bondholder to put the bonds back (sell back to the corporation) at a premium to principal amount of the bond if a qualified change-of-control event occurs.

    Common change-of-control events include the sale of substantially all assets, the acquisition of more than 50 percent of the issuer’s common stock by a third party, a merger with another company, and a liquidation of the company. This covenant effectively safeguards the bondholder against a firm taking on substantial leverage (as in a leveraged buyout) and weakening the bondholders’ positions.

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