Bond issuers may wish to pursue an unmodified reverse Dutch auction for debt repurchases, an effective but underutilised transaction template that is gaining popularity.
During the second half of 2022, amid ongoing market dislocation and as debt trading prices shrunk, paring back financial obligations by repurchasing debt at a discount became an increasingly attractive option for PE-owned businesses. Beyond the more commonly encountered issues that companies must navigate when embarking on debt repurchases (see Navigating Debt Repurchases in Europe: What You Need to Know), borrowers have taken a fresh look at liability management templates. Dealmakers have deployed unmodified reverse Dutch auctions with increasing frequency — a development that we see continuing to gain traction as long as the current economic slowdown and tight financing conditions persist.
What can be bought?
While leveraged loans and corporate bonds can be attractive targets for buybacks, loan repurchases are extremely rare in practice. Loan investors (such as CLOs) are typically less inclined to sell than bond investors and loan documents tend to constrain buyback funding sources and require borrowers to conduct buybacks through open solicitations that offer all lenders the ability to participate on equal terms. Taken together, these strictures discourage loan buybacks and narrow the field of viable debt repurchases to bond buybacks, which have long been a mainstream avenue for managing financial liabilities.
When it comes to bonds, open market repurchases are the most agile and convenient way of retiring debt obligations and are generally permitted by bond indentures and trust deeds. Issuers, acting through a broker dealer, can quickly and anonymously enter the market and seize sale orders at depressed prices. But limited trading activity and scarce liquidity in the corporate bond market often limit the amount of debt that can be taken out in this way to a fraction of outstanding principal and cap the size of open market repurchase programs to a small range (US$10 million to US$100 million).
Public vs. private
Companies with more ambitious plans must go beyond open market trading and solicit investors directly to generate interest in larger trades. This can be effected privately, by reaching out to large bondholders and negotiating terms bilaterally; or publicly, by announcing a tender offer with pre-baked terms that are available to all bondholders willing to accept.
Privately negotiated repurchases can be laborious, drawn out, and risk signalling financial distress (as they have traditionally been confined to distressed workouts). Regardless of whether the issuer is on an even keel, privately negotiated bond repurchases raise the question why the company is choosing to act in the opaque space of confidential bilateral discussions instead of announcing the program publicly, and why it is favouring a few select holders over others.
On the other hand, the principal shortcoming of public tender offers is rigidity. If US jurisdictional means are engaged, a tender offer will become subject to US Securities Exchange Act rules that place onerous requirements on issuers and constrain structuring flexibility.
Unmodified reverse Dutch auction
Unmodified reverse Dutch auctions (see text box), which remain underutilised despite their effectiveness, have been successfully used on several occasions by issuers in recent months.
The key advantage is the issuer’s ability to capture the discount to par that each holder views as fair compensation for its own individual preference for liquidity and disinvestment. By doing so the issuer can retain the combined surplus that it would otherwise have to turn over to bondholders as a whole if it had to apply the highest clearing price to all accepted tenders. Further, an issuer can utilise an attractive trading window by making an offer that lasts for just a few business days, and close before market conditions change. Unmodified reverse Dutch auctions also benefit from the competitive tension that the offer creates among holders: since each holder is aware that other holders may be simultaneously vying to sell the bonds, the holder is incentivised to tender at the lowest acceptable purchase price or risk being displaced by more attractive tenders.
The principal disadvantage of unmodified reverse Dutch auctions is that the tender offer cannot be made to investors in the US, which limits the scope of this transaction structure to debt securities for which there is no significant US market interest.
We anticipate that if economic uncertainty and depressed bond prices persist, a growing number of issuers of non-US-dollar denominated bonds may wish to pursue an unmodified reverse Dutch auction for debt repurchases as an alternative to more traditional liability management strategies.
|Unmodified reverse Dutch auction — Key features
— In a tender offer structured as an unmodified reverse Dutch auction and not extended into the US, the issuer invites holders to tender bonds at a price specified by the tendering holders, rather than at a price specified by the issuer, and announces its intention to accept as many bonds as needed to purchase the desired number of securities, beginning with bonds for which the lowest price has been specified.
— Each holder whose tender is accepted receives the price specified in its own tender, which may be higher or lower than the price paid to other holders whose offers have also been accepted, as there is no clearing price that must be paid to all tendering holders.
— The issuer may wish to specify at the outset the price range it intends to pay and the quantum of securities it wishes to purchase, but is not required to do either and can opt to determine both at its discretion after the offer has expired.
— A tender offer so devised is called a reverse Dutch auction because the auctioneer is the purchasing issuer rather than a seller and because prices ascend as the auction unfolds rather than descend, as they would in a traditional Dutch auction.
— It is also styled as unmodified because it does not have to undergo adjustments that would be necessary for it to be fully compliant with US securities laws, including a minimum 20 business day offer period, specification of a narrow price range at the outset, and payment of the same clearing price for all accepted tenders.