Beware the Dreaded 'Make-Whole': Private Placement Insurance Company Debt.

You're a CFO. Times are good, and you receive an offer you can't refuse - 7-10 year, $100 million term financing. No bothersome collateral. A relatively low fixed-rate coupon for such a maturity - call it 5.50 percent. A pre-negotiated term sheet leading to reduced lawyer haggling and, ultimately, reduced transaction costs. Sounds good, right?

These are the earmarks of the traditional private placement debt market - a corporate debt market provided by U.S. insurance companies that indeed constitutes one of the true cornerstones of American finance. And over the years, many CFOs across the country have in fact signed on the dotted line and have tapped this important market for their corporate debt.

For many, it has been absolutely the correct decision. The private placement insurance company debt markets do provide relatively low-cost, long-term, unsecured financing. However, if the economy suffers, corporate profits swoon and lenders start instituting defaults, a two-word phrase can be heard ringing down the halls of corporate America - "make-whole."

The Refi Pain

You're a CFO, and now times are not so good. Your company is no longer investment grade, and is in default under the financial covenants contained in the private placement debt agreement pursuant to which these long-term, fixed-rate unsecured notes were issued. You've missed your numbers and missed your covenants. The insurance company lenders that bought these notes have told you that they want "out." They demand that you refinance the notes. And, adding insult to injury, they demand payment of a prepayment premium of sorts - the dreaded "make-whole"

"Make-whole" may not sound so bad, but, unfortunately, the "make-whole" amount can be a really, really, big number - a devastatingly large number. For example, for some recent refinancing deals ranging between $90 million to $200 million, the make-whole amount ranged from $13 million to $22 million. Ouch! For some perspective, imagine if you had to pay a $75,000 prepayment premium on your $500,000 home mortgage - it's about the equivalent.

Defining ‘Make-Whole'

Make-whole is the term used to describe the amount over par that the issuer of notes is required to pay in the event the issuer desires to, or, as is quite often these days, is required to, prepay or refinance the notes prior to their stated maturity.

The make-whole amount is calculated by determining the present value of the interest that would have accrued on the notes through their originally stated maturity, all as if the notes had not been prepaid. The present value calculation uses a discount factor, referred to as the "reinvestment yield," equal to the treasury rate corresponding to the remaining maturity of the notes (plus, typically, 25 or 50 basis points).

The reinvestment yield represents what the investor can now theoretically earn by reinvesting the prepaid principal in a relatively safe investment. Not surprisingly, given its name, the make-whole feature is designed to give the investor the benefit of its economic bargain as if the notes were held to maturity and to make the investor whole, notwithstanding the early prepayment.

Further, make-whole is payable not only when the issuer voluntarily prepays the notes for its own internal reasons, such as a recapitalization of its balance sheet or a refinancing to reduce interest expense. Rather, insurance companies insist upon - and private placement loan documents will invariably provide for - make-whole even when it is the insurance companies themselves that call a default and force the issuer to refinance them out.

It is this "forced refinancing" scenario that is most disturbing to CFOs. Paying a premium in the case of a voluntary prepayment is one thing. After all, it is the issuer that is depriving the noteholder of the benefit of the remaining interest-payment stream. But it is quite another matter, from the perspective of the CFO, if his or her company is being forced to refinance the notes because the insurance companies are not willing to waive covenant violations beyond the control of the issuer. It is the payment of a make-whole premium in this context that is most distressing.

Insurance companies will argue adamantly that such yield protection is the price of a relatively low, long-term, fixed rate. Borrowers will argue that the insurance company lenders should not be compensated for the entire portion of the interest they would have received, since they are not making an outlay of cash, and therefore an outlay of risk, during this entire time. But regardless of who is right and who is wrong, it is the CFO that must account for this hit to net income.

Pre-Closing Considerations for the CFO

Before signing onto the issuance of private placement insurance company debt, CFOs should understand the potential extraordinary impact of make-whole in an early refinancing context.

• First, understand the amounts involved. Run some projections assuming prepayment in the first years of the deal, using your best estimates as to where interest rates will be at those times. Understand the extent of the make-whole risk your company is undertaking.
• Second, like any financing, obtain the most lenient financial ratio covenant package you can negotiate. The longer your company stays out of default, the longer you can avoid the dreaded forced refi scenario and reduce or eliminate the dreaded make-whole itself.
• Third, proceed cautiously if your company is especially cyclical or is in an industry sector that could face a downturn. Otherwise, basically sound but cyclical businesses can often stumble on the financial covenants, resulting in a potential forced refinancing.
• Fourth, because make-whole is payable in a voluntary prepayment context as well, consider whether there are any potential transactions or events on even the mid-term horizon that could fundamentally change the company's corporate structure or character. Examples include a potential change of control, a significant equity issuance or other recapitalization or a significant acquisition or divesture. If such events are likely, either build them into the agreement so that they are permitted or carefully consider whether the private-placement market is for you.
• Fifth, consider other long-term financing alternatives, including the public debt markets. Yes, public bonds do typically contain extended no-call periods. Further, even when the bonds become callable, they come with substantial premiums. However, the key difference between public debt and privately placed debt in this regard is that public debt instruments do not contain financial ratio maintenance covenants that give rise to the dreaded forced refinancing scenario. As a result, it is far easier to stay out of default with public debt. The transactions costs may be higher but the make-whole risk is reduced.

When Make-Whole Stares You in the Face

So, what do you do when you are looking at a $15 million make-whole payment in a forced refi scenario? Negotiate. For the most part, experience has shown that insurance companies will forgo all or a portion of the make-whole in exchange for receiving 100 percent of their principal if they sense a true distressed or workout credit.

But, to get to this result, you must either actually be poor or cry poor effectively! Obviously, actually being poor has its own hurdles - first and foremost of which is the ability to obtain refinancing in the first place. If the issuer is in a tenuous position financially, it may be unable to obtain sufficient refinancing to repay principal, much less make-whole.

However, if the issuer can obtain alternate refinancing, crying poor effectively is still tricky. The issuer must demonstrate to the insurance companies that it has just enough collateral or cash flow to refinance the notes at par but not enough to pay any additional make-whole amount. While this can often be the true state of the issuer's financial affairs, it is often difficult to convince the insurance companies of this fact.

Depending upon the gravity of the situation, the insurance companies may waive the make-whole. For instance, a series of failed refinancings is an obvious signal that the issuer has real problems and, if presented with a refinancing that pays principal at par but no make-whole, the insurance companies may very well take that deal.

Often, if cash or collateral is tight, insurance companies will accept deferred subordinated notes or preferred stock or other equity, or simply reduced make-whole, depending upon a range of factors. These include the amount of make-whole involved, the issuer's true (and perceived) financial state, the intransigence of the noteholders and, perhaps, the effectiveness of issuer's counsel.

Also, CFOs are encouraged to be skillful in playing groups of lenders against one another. Commercial banks despise make-whole just as much as the issuer that is obligated to pay it. The banks can place pressure on the insurance companies to accept a refi that pays less than the full make-whole amount. If the issuer can present a picture of true financial distress, some or even great success can often be had.

In this same vein, attempt, with the aid and comfort of other lenders, to subordinate the make-whole portion of the insurance company claims in any intercreditor negotiations-whether before or after default. As a corollary, avoid whenever possible securing the make-whole obligation with any collateral security. The lower the make-whole is in the waterfall of payment, the greater chance for success in avoiding or reducing make-whole. Sometimes, your other lenders can be your best friends.

Richard W. Grice is chair of the Leveraged Capital Group of Alston & Bird, a national law firm headquartered in Atlanta.
(This article first appeared on Financial Executive Online, November 2003)