The Whole Truth

Whole company securitization is helping non-investment-grade companies raise capital and recognize intangible assets on their balance sheets, but can it overcome its checkered past?

Whole company securitization (WCS), sometimes called whole business securitization or operating company securitization, is a more complex version of traditional securitization. A parent company isolates revenue-producing assets — often the trademarks or patents that are the “crown jewels” of its intellectual property — by selling them to a limited-purpose, bankruptcy-remote shell company. The shell issues bonds backed by the assets and uses the proceeds to provide a secured loan to the parent.

One important distinction from a traditional securitization is that a WCS deal entails few, if any, contractual obligations to deliver funds. The assets must be actively managed, usually by the parent under agreement with the shell, to generate continued cash flow and to preserve their value.

Like the traditional model, however, whole company securitization requires that the assets can be protected from the parent’s creditors. To be sure, the Days Inn case of the late 1980s — when the parent company entered Chapter 11, and the bankruptcy remoteness of its shell entity was put to the test — has haunted the WCS market ever since. (See “Ghost in the Machine,” at the end of this article.)

WCS is a hybrid structure, notes Ira Schacter, a securitization attorney with Cadwalader, Wickersham & Taft. Because it mixes traditional lending with a securitization that isolates a cash flow stream, the issuer — that is, the shell company — will ask rating agencies to analyze how steady EBITDA is likely to be, and it will treat the flow as if it were a receivable subject to business risk. The magic of WCS, maintains Schacter, “is allowing companies to borrow against amortized debt on a going-forward basis.”

Robert D’Loren, president and chief executive officer of boutique investment bank UCC Capital Corp., likens WCS to cash-flow lending, “but in a highly structured manner, as opposed to just lending against EBITDA.” So why choose WCS over a cash-flow loan?

Reasons to Be Cheerful

“More bang for the buck,” suggests Donald Camacho, chief financial officer of The Athlete’s Foot Group. “A company with a low credit rating may never be able to secure a cash-flow loan,” or at least not for a reasonable rate. Camacho also reckons that non-investment-grade companies would wind up in the junk bond market, where management would pay higher interest rates for reduced proceeds.

Only about 25 WCS deals have been completed in the United States since the Days Inn deal, and the proceeds have been small — usually between $25 million and $100 million. However, the pace is quickening: UCC’s D’Loren estimates that 14 deals were completed during the last 12 months. Officials at Moody’s Investor Services claim that several WCS deals are the credit rating agency’s pipeline, although they won’t divulge the number.

The newness of the class, and the complexity of the deals, makes WCS a hard sell. “Each case is different,” says Ellen Welsher, a managing director at Standard & Poor’s. Companies have a hard time finding precedents, she point out, because only a handful of deals have been rated and historical databases don’t yet exist.

Then there’s the touchy matter of who controls those intellectual property crown jewels. In most WCS deals, the shell company is run by former employees of the parent who have been “transferred” — although they never actually change desks or phone numbers. Often they then retain their colleagues at the parent company — who may be just down the hall — to manage the assets.

Since the shell has issued bonds backed by those assets, and since the revenue stream that services the debt depends on how well the assets are managed, a WCS deal incurs operating risk. To mitigate that risk, most WCS deals entitle the shell company to act on behalf of bondholders and substitute pre-approved backup managers. That can make for some hard feelings if the parent and shell companies share a water cooler.

Exposing proprietary data to the backup manager is an operational sticking point in itself, since “the ideal backup manager is often a competitor,” notes Nicholas Weill, a senior vice president of Moody’s. “You don’t want to share your Rolodex and strategy with them.”

Longer lead times are another deterrent. WCS deals don’t sail through a ratings agency in a week, as a securitization of mortgages or auto loans might do; Weill contends that between three months and two years might be needed to identify operating risks in the business sector, make arrangements with a backup manager, and perform balance-sheet analysis, among other things. Legal technology and underwriting skills also have to play catch-up with this newer asset class, adds Dick Rudder, an attorney with Baker & McKenzie.

Finally, ushering the transaction through management “is not a 20-minute process,” declares Camacho, who completed a franchise-fee securitization for the Athlete’s Foot Group in August. At his previous job, sneaker maker Converse Inc. pulled the plug on a WCS deal at the last minute, according to Camacho. As he tells it, management balked at operating changes mandated by the bank and rating agency to lessen operating risk; they wouldn’t outsource production to an overseas manufacturer or transfer the Converse trademark to a shell company.

“Management that is trying to secure highly rated debt should realize that they can’t necessarily do things the way they did before,” observes Moody’s senior vice president Michael O’Connor. “This type of securitization can change your business.”

Absolute Beginners

Many of the companies that investigate WCS are attempting securitization for the first time. The issuers are often unsophisticated in capital-markets transactions and unprepared to generate the type of operating information that the securitization market mandates. For instance, says Moody’s Weill, in addition to typical financial ratios, his ratings agency collects asset-related information such as franchise growth rate, number of sales per store, vendor delinquencies, and payment rate of purchasers.

The best candidates for WCS are companies that operate in markets with high barriers to entry and low competitive risks. Their brands should have already proved their value; cash flows from new products are too unpredictable.

“Mid-market companies find [WCS] compelling,” says UCC’s D’Loren, “because they are often capital constrained” compared with Fortune 500 companies that can achieve the same cost of capital using many other financing options. D’Loren also maintains that companies might use WCS to provide liquidity for a change in business model, for growth through acquisition, or for a management buyout.

In November 2000, Triarc Cos. Inc. found WCS compelling enough to issue a 20-year, $290 million securitization backed by the franchise fees and trademark royalties from its U.S. and Canadian Arby’s fast-food restaurants. Triarc — in structuring the first major U.S. trademark deal since the Days Inn debacle — added a number of financial and legal enhancements. Ambac Assurance Corp. was brought in to guarantee the bonds, employing a reinsurance arrangement from Swiss Re New Markets; a debt-service reserve account trapped excess funds to provide short-term liquidity in case operating performance should drop; and as an incentive to the backup managers, their fees were predetermined.

Moody’s rated the Arby’s deal Aaa, primarily on the strength of the Ambac guarantee. At the time, O’Connor noted that the securitization would have been rated at least investment grade even without the Ambac backstop. S&P rated the deal AAA.

What really made the Triarc deal work, though, says Cadwalader’s Schacter, is that “Arby’s is a really old, tired brand with a loyal and stable customer base,” and it doesn’t rely on national advertising or growth for new customers, as do other Triarc properties.

What made Camacho’s deal work at The Athlete’s Foot Group, on the other hand, was the ability to recognize AF Group’s intangibles — “like finding hidden gems,” says the finance chief.

In August, Athlete’s Foot Marketing (one of the group’s companies) sold its trademark and more than 550 franchise fee contracts to a shell company called Athlete’s Foot Brands Inc. AF Brands issued 11-year notes, securitized by franchise fee revenues and trademark royalties. The bond issue, which Camacho says was in excess of $25 million, was rated Baa3 by Moody’s. AF Brands also hired about 25 AF Marketing employees to manage the assets.

Cheaper capital isn’t always the objective of whole company securitization, observes Camacho; in terms of interest rates, the capital that he extracts from this WCS deal costs about as much as the company’s inventory financing, “so it wasn’t the cheapest capital the world.” In fact, some bankers maintain that the upfront costs of securitizing the assets of an entire business line can be up to 10 times the cost of issuing corporate debt. However, since AF Group was able to replace short-term debt with a long-term bond, those initial costs are more than offset by the improvement in the weighted average of capital.

And those “hidden gems”? Camacho explains that, in a simple world, AF Marketing would have shown just cash and debt on the books at the completion of the securitization. However, because the company went through a management buyout four months later, goodwill accounting rules allowed for the value of the brand and franchise agreement to be recorded on the financial statements. “All of a sudden, my [AF Marketing] balance sheet goes from having no assets to over $50 million in assets,” avers the CFO. At press time, he was waiting for an independent valuation of the brand and franchise fees, which Camacho expects could climb to $65 million.

Apparel maker Guess Inc. completed a $75 million royalty deal of its own in January 2003. The company moved the Guess trademark to a shell called IP Holder LP. which then issued bonds backed by the royalty license fees it collects from 14 accessory manufacturers that use the trademark on handbags, belts, shoes, jewelry, and the like.

Before the deal was completed, Standard and Poor’s analyzed the impact of a hypothetical bankruptcy of the parent company, Guess Inc., on the shell company’s cash flow. S&P associate general counsel Sabine Zerarka maintains that since the intellectual-property assets have been transferred to the shell in a “true sale,” not a fraudulent conveyance, the parent’s hypothetical creditors would have no claim on the assets should Guess fall into Chapter 11. Furthermore, because the trademarks and license agreements supporting the WCS represent only 5.4 percent of the parent’s net revenues, the “core assets argument” raised in the Days Inn case would not likely succeed here.

Critics of whole company securitization stress, however, that these complicated transactions have never been tested in bankruptcy court. To be sure, one reason might be that most shell-company trustees quickly settle with bondholders, perhaps to avoid the possibility of losing everything to a parent company’s hungry creditors.

The WCS market will never equal the mammoth asset-backed securities market for trade receivables or residential mortgages, says Moody’s managing director Jay Eisbruck, but he does predict slow, continued growth for the new asset class. For WCS to “take off,” opines Dick Rudder, a securitization attorney with Baker & McKenzie, it would have to become “the focus of the major investment banks.” Rudder believes that the banks would then harness the industry knowledge of their sector groups and marry it with their securitization technology and marketing expertise.

That day may be closer than you might think. Bankers from some of Wall Street’s largest dealmakers cite the $1 billion DreamWorks SKG movie securitization in 2002, and the $750 million Vivendi Universal Entertainment deal in 2003, as proof that more-substantial WCS deals are just around the corner. Other banking sources claim that bulge-bracket firms will bring a few more billion-dollar deals to the market before year’s end.

Marie Leone is a senior editor of CFO.com.

Ghost in the Machine

The $155 million intellectual-property securitization of the Days Inn of America hotel chain — the first whole company securitization in the United States — probably still figures in sleepless nights for potential dealmakers. When the parent company filed for Chapter 11 protection in the late 1980s, the shell company’s independence was put to the test.

Some experts say that the Days Inn deal proved the strength of the shell company’s bankruptcy remoteness. Others claim the deal was a failure. At issue is why the solvent shell, which held the Days Inn trademark, agreed to a voluntary reconsolidation with the insolvent parent — essentially sending the shell company into bankruptcy, too.

Dick Rudder, an attorney with Baker & McKenzie, explains that although the deal’s structure transferred the trademark rights to the shell, the parent needed that asset to reorganize and begin operating again under the Days Inn name. Apparently the bankruptcy remoteness was so ironclad that in the eyes of the bankruptcy court, the reconsolidation of the shell was the only way that the parent would have been able to recover the trademark asset.

What transpired remains puzzling. A trustee of the shell company convinced it to enter Chapter 11 with its parent, and a settlement was quickly reached to offer bondholders 95 cents on the dollar — reportedly to avoid a court battle between the shell and the parent over ownership of the Days Inn trademark. Some observers have pointed out that a court challenge to the WCS could have set a dangerous precedent for all such deals.

Rudder and other experts, however, maintain that this deal was in trouble from the beginning. For one thing, the parent company seemed to have transferred a core asset — since the settlement proved that the trademark was necessary to the parent’s ongoing operation. In fact, some sources reckon that the transfer of the Days Inn trademark was akin to a fraudulent conveyance; the assets should have been clear of all liens of the parent company when they were transferred to the bankruptcy-remote shell.

What’s more, the reconsolidation of the shell and the parent was allowed on the basis of certain facts that are not usually present in a well-structured deal, says Sabine Zerarka, associate general counsel with Standard & Poor’s. She points to the commingling of parent and shell accounts and other operating and financial entanglements. “It was a real failure of the barriers that are usually put in place in securitization,” adds Zerarka.

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