Income Deposit Securities
By Samuel R. Kwon
US power companies may be able to use income deposit securities to cash out of power projects.
Coinmach Service Corp. became the third company to use an IDS structure in the United States in November 2004. The owners of Coinmach, a corporation near New York City, offered 18.3 million income deposit securities as a way of selling down equity in the company. The company raised $14.25 to $15.75 a unit for the securities and then used the cash to redeem part of the equity interest of the existing owners. Each IDS represents one share of common stock and one subordinated note. The debt portion of the Coinmach’s IDS offering represents an aggregate principal amount of $123.75 million worth of debt. Coinmach leases laundry machines in apartments, and owns and operates retail laundromats.
In December 2003, CenterPlate Inc. (formerly Volume Services America Holdings, Inc.) was the first company to come to market in the US using the IDS structure, raising $277 million, of which $124 million was debt. CenterPlate is a concessionaire in various sports stadiums in the US.
B&G Foods Holding Corp. was the second company to use the IDS structure in October 2004, raising $261 million. Of that amount, $96 million was debt. B&G Foods is a seller of food items, including the Ortega brand.
The securities offer shareholders in closely-held corporations with a stable cash flow and some prospect for growth a way to cash out of such companies. Blackstone Group and GE Capital Corp. used the securities to reduce their holdings in CenterPlate. Bruckmann, Rosser, Sherrill & Co. sold down its ownership of B&G Foods through the IDS structure.
Holders of income deposit securities receive a yield currently in the 10% range.
The IDS structure is still somewhat in flux. B&G Foods has had to amend its filings with the US Securities and Exchange Commission 11 times, significantly altering its dividend policy in the process. Eighteen companies have filed to offer income deposit securities in the last year, representing a potential issuance of up to $9.6 billion, but none except the three companies described earlier has been able to come to market. In September 2004, several companies, including American Seafoods Group and Iowa Telecommunications Services, Inc. abandoned their efforts. Accounting and law firms involved in the issuance of the securities continue to tinker with the structure to get comfortable with the tax and accounting issues posed by it.
An IDS is a security representing one share of common stock and one subordinated note in the issuing company. Its holder receives dividends on the share and interest on the note. The IDS is tradable on a US stock exchange. The investor can separate the equity and the debt piece after a fixed period and can also recombine them later.
In the case of CenterPlate, approximately 60% of the income deposit securities were placed with institutional investors with the remainder going to retail investors. Eighty percent of the investors were in the US and 20% in Canada. The IDS structure was originally envisioned as a way to replicate benefits from Canadian income funds, but in a manner that reduces some of the tax risk associated with that structure. (See the December 2003 NewsWire for an article on Canadian income funds.) The CenterPlate securities are listed on both the American Stock Exchange and the Toronto Stock Exchange. Approximately two thirds of the B&G Food’s securities were placed with institutional investors and one third was sold to retail investors. Almost all investors in the B&G Foods offering were in the US. The B&G Foods securities are listed solely on the American Stock Exchange.
An IDS may go by another name. A version of an IDS structured by RBC Capital Markets – the lead manager on the B&G Foods offering – is called an “enhanced income security,” or EIS. Its Canadian counterpart is called an “income participating security,” or IPS. A version marketed by Goldman Sachs is called a “yield oriented unit,” or YOU.
Investors like income deposit securities because they generate predictable cash flow in an era when many investors have grown weary of accounting scandals and corporate governance controversies. Investors wary of earnings from creative accounting are especially attracted. Current yields are high compared to other investments.
Company owners like the IDS structure because it allows them to sell down their interests in a company well above the 25% commonly sold in traditional initial public offerings of stocks. The types of companies that are attractive to the IDS market – companies that generate stable cash flow, have at least some modest growth prospects, and can tolerate leverage – are typically not well suited for the IPO market where investors are more interested in companies with high-growth potential. The IDS market focuses more on predictable cash flow. Companies using the securities this fall were assigned higher values by the market than are typically achieved through private sales or traditional IPOs, with yields of up to eight times the distributable cash in the case of CenterPlate and B&G Foods. The securities also give companies using them flexibility in whether to pay holders through dividends or interest.
An IDS is valued principally on a yield basis. Essentially, its value is derived by dividing the distributable cash by the yield. Distributable cash is earnings before interest, tax, depreciation and amortization, or EBITDA, minus capital expenditures relating to maintenance, interest on the senior debt borrowed outside the IDS structure, cash tax payments and other administrative expenses. As a result, the companies most suitable for the IDS structure should have a stable cash flow, a modest prospect for growth, and a low potential for unexpected capital expenditure. A company that expects to have to make large capital expenditures is not a good candidate since such expenditures tend to reduce the cash available for distribution, which in turn may reduce the value of the securities.
Income deposit securities are appropriate only for corporations. The basic structure is not complicated: the corporation issues securities to investors each of which represents a share of common stock and a fractional interest in a subordinated note. The dividend policy on the common stock is determined by the board of directors, and the IDS holders are not entitled to guaranteed dividends. The subordinated note portion is similar to typical high-yield debt, but its maturity may be longer than 10 years and may have interest deferral provisions.
The corporation borrows additional money from third-party lenders as the same time as the IDS offering. For instance, CenterPlate procured additional debt through the private placement market while B&G Foods did the same through the bank market. The reason for the senior debt is to provide additional working capital for the company.
The IDS structure continues to change. Each change is primarily geared towards making sure the debt component of an IDS is respected as an instrument separate from the equity component and is respected as true debt under the US tax laws.
The tax treatment is important because it is essential the corporation be allowed to deduct the interest that accrues on the subordinated note. The first hurdle is a risk that an IDS unit may be treated as a single equity instrument if there is an economic compulsion to keep the debt and equity components of an IDS together. Tax lawyers advise making sure there is enough liquidity in both components to make them severable in practice in the market.
Assuming the debt and equity components are respected as separate instruments, the next hurdle is to ensure the subordinated note part of the IDS is respected as true debt rather than equity parading as debt. Three features typically found in the debt component of an IDS present potential difficulties. First, the debt component of an IDS unit is deeply subordinated, and is usually the most junior debt of the issuer. Second, the interest rate may be too high (and the holders may not care since the same holders also hold the equity). Third, there may be an identity of the equity holders and the debt holders.
The big four accounting firms reportedly have developed five specific requirements to address the tax risk.
First, they recommend that at least 10% of the subordinated notes be placed separately outside the IDS structure. These are called “bachelor bonds.” The terms of the bachelor bonds are identical to the terms of the debt portion of IDS. The accounting firms require that the bachelor bonds be sold to investors who are not also holding equity in the corporation. This creates a class of debt holders who are holding notes identical to those forming part of the IDS, but do not hold equity in proportion to their debt.
Second, at least 10% of the common stock of the corporation should be held by other shareholders who do not participate in the IDS. This other equity should not have a right to convert into income deposit securities for some period – for example, two years. These other common shares are referred to as “class B shares.” The bar against conversions imposes a real burden on the holders of the class B shares since they stand behind the holders of the income deposit securities in line. The IDS holders are also subordinated lenders and not solely equity holders.
Third, the debt portion of the IDS should rank at least pari passu with trade creditors. This is to help distinguish the debt portion of the IDS from merely a more senior tranche of equity.
Fourth, the underwriter of the IDS must represent a current intention to make a market in the bachelor bonds, as well as the separate components of the IDS - both debt and equity.
Finally, the covenants in favor of the debt holders of the issuing corporation must bar the corporation from paying dividends on shares after an event of default (or in the event the interest deferral period is triggered, if the subordinated notes have this deferral feature). This restriction may be waived or amended only with the unanimous consent of all lenders (including the senior lenders).
One legal advisor involved in the latest IDS offerings said his law firm offered a tax opinion that the IRS “should” respect the debt characterization of the debt component of the IDS and allow the interest payments to be deducted by the issuer. The corporation using the securities took the position that a “should” opinion was enough to avoid having to set up a reserve against the possibility that the IRS would disallow the interest deductions.
Each IDS unit may be separated into its debt and equity components after a time, but separation to date appears rare. For instance, of the 16 million IDS units issued by CenterPlate, during the eight months following the offering, a single holder chose to separate the common stock from the subordinated note.
The IDS structure allows the issuing company to make “follow-on” offerings of additional IDS units. This is important because in all IDS offerings there will be a retained equity stake by the sponsors in the form of class B stock, and the sponsors will want the ability to exit by exchanging (or converting) their retained equity for IDS units.
Each future IDS unit should be the same as the initial IDS units. If not, the new notes are not the same “issue” as the original notes for tax purposes, the new notes would receive their own CUSIP numbers for trading purposes, and would not be fungible with the original notes. Less fungibility means less trading liquidity. Unlike an initial public offering, an IDS offering is an offering of both stocks and notes. Notes issued at different times may not be fungible with one another because of the possible presence of original issue discount, or OID.
In order to overcome this problem, the financial and legal advisors to the most recent proposed IDS offerings have come up with an “automatic” exchange mechanism. Suppose A buys one IDS consisting of one common stock and one note without OID. Then the company issues an additional IDS to B the next year, consisting of one common stock and one note with OID. Through the automatic exchange provisions in the indenture governing the issuance of the IDS units, both A and B are viewed each as owning one IDS consisting of one common stock, half a note without OID and half a note with OID.
This means an original holder of an IDS may end up with some notes having OID upon follow-on offerings of IDS unit, causing him to report more interest income than anticipated and having a capital loss (or less capital gain) upon sale of the notes or at maturity. In addition, this automatic exchange mechanism is arguably a taxable exchange for the original holder although there is no clear answer in the US tax laws. None of the filed prospectuses takes a definitive position on the taxability of this deemed exchange.
Participants in the recent IDS offerings all agree the US Securities and Exchange Commission has still not decided what is the proper level of disclosure required in these offerings. The SEC appears especially concerned that most IDS marketing literature suggests that the debt and equity components together should provide a yield of about 10% when in fact the dividends could be suspended if the company falls behind on payments of interest and principal on its senior debt, and interest payment could be deferred as well. In the case of B&G Foods – in which there was no interest deferral provision – the company eventually created a cash reserve of $6 million that it could use to pay investors dividends or to even out the company’s cash flow.
Accounting firms have not reached a consensus on the treatment of certain option-like features found in the IDS offerings. For instance, a holder of a class B stock –- retained by the sponsors – has an option, after a time lag, to convert the common stock into subordinated notes – identical to the debt portion of the outstanding IDS units – at a predetermined rate. CenterPlate agreed to treat these options as “embedded derivatives,” thus recording approximately $3 million as of March 2004 as a liability for derivatives on its balance sheet. It has promised that “each quarter this option will be fair valued and any change in the underlying value will be either charged or credited to interest expense on the operating statement.”
Once investors became comfortable with the Canadian income trust structures, many publicly-held companies in Canada converted to that structure. A financial adviser currently involved in preparing a number of potential IDS offerings indicated that one can foresee public companies converting to the IDS structure eventually once the public gains confidence in it. The prime targets for such conversion, or new IDS offerings, would continue to be corporations with assets that generate a stable cash flow, including potentially government-owned infrastructure like toll roads and energy and water projects that may be put up for privatization using the IDS structure.