Who’ll buy Constellation’s risky debt? Shareholders

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If you're a company issuing debt, you want two things. First, you want to limit your interest payments on the debt. While interest can be deducted against taxable income, interest is also an expense that requires cash flow, and it's something that increases the riskiness of a company. Second, you want freedom to run your business the way you think is best. Debt covenants put constraints on a company's ability to freely operate. In an ideal world, you'd issue low interest debt that is light on covenants.

Except you can't have that. From a debt investor's perspective, fewer covenants means more risk – the company can issue more debt and subordinate current debt holders, which means that the company may avoid or delay the payment of interest – and investors need to be compensated for that through an increased interest rate. Thus, so-called "covenant lite" bonds tend to pay a higher interest rate. There are no free rides.

On first pass, Constellation Software's new debenture looks unappealing. Constellation wants to use this debenture to pay down a more traditional, $650-million credit facility it has with a bank and it initially looks like a tough sell.

While it offers a 6.5 per cent coupon that's indexed to inflation and therefore shouldn't erode over time, Constellation president Mark Leonard suggested in an April 30 letter to shareholders that the rate is below what investment bankers recommended, and the debenture gives investors an extremely light covenant package. Not only is the debt is unsecured and subordinated to the company's existing credit facility, it matures in 2050, requires five years notice before the company can be forced to buy back the debt and contains an aggressive, paid-in-kind-like covenant (a PIK covenant).

Also, from the prospectus, under the PIK-like covenant, Constellation is allowed to miss an interest payment and not default on its bond. If this happens, interest payments are rolled over into principal, making it increasingly likely that an investor will never see his investment back. Usually, an extremely high yield would be necessary to make this bond saleable.

So who would buy Constellation's debenture? Constellation is issuing the debenture through a rights offering, meaning that only equity holders can buy it. Constellation is making a bet that equity holders will be interested in their seemingly unappealing instrument. And they may just be right.

Constellation's business involves purchasing vertical market software companies – firms that build industry specific software products. In short, Constellation grows through acquisitions and has been very successful in doing so, the stock has grown rapidly and Constellation now has nearly $5-billion in market capitalization. To finance itself, Constellation has a $650-million credit facility with various banks.

Of course, banks have demands and those demands include covenants. Banks like shorter term debt, they like debt that can be redeemed prior to maturity and they like it when companies don't skip interest payments. In the April 30 letter, Mr. Leonard stated that he didn't want to rely on debt that was that restrictive. Given Constellation's business model, this makes sense – Constellation has to be able to weather a bad or expensive acquisition and it has to be able to engage in further acquisitions, and covenants may restrict its ability to do so. It wants the flexibility to use its cash flow in a downturn to make acquisitions at a discount.

Equity holders don't have the same set of concerns as investors that don't also own equity. As the residual stakeholders at the bottom of the capital structure, equity holders gain the benefit of anything that's left over after paying debt. If more debt increases a company's ability to engage in positive value transactions, equity gets the benefit of anything that's left over. Not only can leverage magnify returns, but a low interest rate benefits equity because equity doesn't see its residual benefit eroded by high interest payments.

Constellation's rights offering plays off this insight. From the equity holders' perspective, a covenant lite, lower interest package may be a very good thing. A stricter covenant package would limit Constellation's business model. With stricter covenants, incremental debt issuance would be more challenging, limiting Constellation's ability to fund transactions. Interest payments, generous put rights and a shorter maturity would force management into more conservative cash management, limiting the company's flexibility to pursue strategic alternatives the upside of which accrue to the equity holders.

Meanwhile, equity should be less fussed about lower interest payments. Equity should be happy if Constellation can get debt at below market rates that will help the company continue with its business plan, because equity will see the benefit of any increased growth. At the same time, if the debt is underpriced, equity will gain the benefit of the excess cash the company retains from the below market rate as part of its residual interest.

Similarly, equity is okay with the PIK-like covenant. If Constellation misses an interest payment, the benefit will be added to principal, not send Constellation into default (a situation that equity would like to avoid), and allow it to use its cash to keep the acquisition machine rolling. While failure to pay interest means that equity holders will no longer be entitled to a dividend, the debenture offering likely means a dividend cut anyway, and equity holders will have a larger claim over the principal. It's really replacing one residual claim with another.

The fact that the debt will be subordinated, while not directly appealing to equity investors, puts them in no worse a position than they were before. It actually moderately improves their position on the capital structure, as the debentures will be used to pay down bank debt that is entitled to payment before the new debentures and is more covenant-heavy.

Still, Constellation's rights offering very much remains a trial balloon. It requires that at least $50-million of the rights be taken up and is capped at $100-million. Equity is being asked to commit more money to Constellation and is being asked to take on risky debt. If things go poorly, the debentures are callable only with five years notice and will likely trade in an illiquid market. For its investment, equity risks being caught with an illiquid asset and a declining stock price. In some ways, then, Constellation's rights offering comes down to trust.

In his letter, Mr. Leonard stated "my experience selling Constellation shares over the years is that you can sell a novel investment to the sophisticated few, and that over time both the size of the audience and the level of trust grow." The question now is, has Mr. Leonard grown that trust enough to sell debt, too?