by fuzzyblankeet
To be honest, I’m impressed you’ve gotten this far. That’s a lot of words in the title. I’ve noticed an unprecedented influx of idiocy into this sub lately, but also a lot of quality explainers, so I wanted to add my two cents. TL;DR – this is a post about credit agreement and bond covenants and their impact on equity pricing (and how you – yes, you in the back with the helmet on) – can use them to your advantage. How the fuck do I know about this? Well, I write ’em for a living. Interested? Read on. Want a ticker? Get fucked. I get charged out at $1500 an hour to explain this shit to CFOs and hedge fund managers, so be grateful I’m here to explain it to you gratis. Don’t worry, we’re going to do a practical example at the end – you can do what you want with that information.
Ever wonder where money comes from? Hurr hurr printer goes brr, I know. But where companies get their money from? Well, there are four main sources of cashflow. (1) Sales (2) Equity (3) Bonds (4) Debt. OK maybe at the moment the Fed makes 5 (but not really). Let’s get started.
Fundamentals
(1) Sales. This is the basic corporate calculus – make shit, sell shit, receive money from the people who buy shit. Some companies don’t even have to do that (looking at you, $APRN). (2) Equity. A bit like (1), but instead of making shit to sell, you cut off pieces of your company to sell to either public or private investors (psst. these are what your options give you a right to buy and sell) So far, so simple. Easy, right? Well, we’re not here to talk about that shit. This is AP debt instruments, retards. That JV shit is for r/investing and for the r/all normies. (3) and (4) are what heavy hitters care about (and where you can get something of an edge).
(3) Bonds. No, not the iconic Australia underwear brand your wife’s boyfriend wears. This is where you issue – either privately or through a public placement – long or short term debt instruments (bonds, notes, paper, whatever – it all means the same shit) to the market. It’s basically an IOU from the company. The hook is that these sell for less than they’re worth (called ‘par’) – and also generate interest (called a ‘coupon’). You sell a promise to repay someone $100m in 7 years for $99m, AND you promise to pay them a coupon on their investment. Plus, they can trade ’em. Literally can’t go tits up! The u/ir0nyman of corporate credit instruments. Why would a company do it? No need for pesky banks – and you can do it quick and dirty for when you need money now for that new Gulfstream the CEO’s been eyeing. (4) Debt. Where most of the real money comes from. This is where a bank and a borrower who love each other very much get together and agree to lend money for a fee on certain conditions. Sometimes it’s two banks. Sometimes, for the more adventurous borrowers, they invite a whole syndicate of banks into the party for a fiscal gang-bang of epic proportion. They spread that risk around like your wife’s boyfriend… well, you get the idea. You use this option if you want more money over more time with more flexibility than in a bond offering.
The Rules
Anyway, so (3) and (4) are in great big beefy documents hidden at the back of 10-Ks that noone other than me and hedge fund managers ever read. Spoiler alert – I am not going to explain things like the difference between a TLA, TLB and revolver to you, or talk about secured and unsecured debt. Loads of the fucking rules in them don’t matter (don’t tell anyone – this is what keeps us in a job). Google it if you’re interested. However, one section *does* matter (a lot). They’re called ‘negative covenants’. Negative means negative. Covenant is a fancy word for ‘rule’. See, the way these documents work is that they’re drafted to say ‘You’re not allowed to do anything EXCEPT for the following’. The neg covenants are the exceptions to the rule that you’re not allowed to do anything.
There are a bunch that are normal, practical rules. Can’t change shit about the company except for shit that doesn’t matter, can’t sell your shit without telling the banks except for shit that’s really cheap, can’t buy stuff except for stuff you need, etc. The big one for our purposes is called INDEBTEDNESS. This is the rule that you can’t borrow more money, except….. And this is where WSB can come in.
Banks are like women. They like exclusivity. They don’t want to give it all up on the first date expecting you to hold them dear and true for the next 5-7 years and then see you out on the town 6 months later with some slutty direct lender. They feel… shame. And also like that there is a risk that you won’t be able to pay *them* back. See, most of what companies actually spend money on is debt service. The interest and fees and shit stack up fast (especially when the company blows its load on some shitty acquisition straight away). So when you can borrow *more* money than you should be able to, your balance sheet can get ugly fast. Good money after bad, etc. – especially with companies than aren’t cash-flow positive to begin with. This raises the risk of default. This can downgrade the credit rating. This can change the stock price.
Now, for the last 10 years, noone has really given a shit about the possibility of default because debt has been so free and easy to access. Stonks only go up, they figured, so what could go wrong? Charge a fee, sell the risk to some dicey Chinese banks who don’t know any better, see ya later. But now with this Corona-shit, people feel like maybeeeee they’re in a position where an already dicey lending proposition to a company without consistent cashflow and that company is about to issue some new bonds. And the syndication market is dead. So, problems. If you have big holes in your indebtedness covenants, you can utilize them to incur additional debt – which *sometimes* you can use for good, and sometimes you can just use to pay off your existing bad debt – kicking the can down the road. Obviously, this is bad for a company’s long term health – but the CEO will be long gone by the time this matters, so who gives a shit, right?
Now you kinda need to be at a level above the average r/wallstreetbets user to wrap your head around what the docs say. They’re pretty complicated. BUT, what even you can do is read a 10-K. Let’s do an example together. $SIX.
Example to work through
$SIX is a shitty company. They’re pretty highly levered. They’ve got lots of debt outstanding. In fact, they’ve got some bonds due pretty soon. Big, expensive bonds. Look at the financials. Lots of interest. Plus, they’ve gotta pay it back. Soon. In fact, $1 billion cash money in July 2024. Bad news for a company with no fucking cashflow for the foreseeable future. Divorced dads not taking little Janey and Johnny to Six Flags over Georgia for the annual ‘Please Don’t Hate Me For Leaving You’ trip anytime soon. So what does SF do now? They don’t want to default on that payment, or they’ll go bankrupt. They look at their loan docs – remember, the baseline is *no more debt except for the following* – to find a way to borrow *more* money to pay these off. Robbing Peter to pay Paul.
If they have a freebie basket (an exception that says they can borrow money for any reason up to ‘X’), then they’re in luck. If they can incur ‘accordion’ debt, even better – this is extra debt on top of what they’ve already got outstanding at a similar level of seniority. This is subject to certain protections but whatever, the important thing is getting the monkey off their back. They can also combine this with, more complex baskets in a feat of linguistic gymnastics that would make Hilary Clinton blush to borrow money to pay off their other outstanding obligations. If they don’t, well, that’s bad.
Have a go. See if you can figure it out for yourself. Can $SIX do it? If they can, great! No bankruptcy! if they can’t, well, bad times ahead – and a big short opportunity for you.
For those of you who’ve read this far, here’s a neat trick – you don’t even need to read the fucking Credit Agreement. All this shit is in the 10-K under ‘Debt Obligations’. They put it all there in black and white for you to find.
How you can do this too; the TLDR of the above
Find a bad company. Read their 10-K. Look for bond debt expiring soon. See if they can incur debt to pay it off. If not, short the shit out of them on a 6-12 month basis. Get tendies. Repeat.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.