Last week, the ongoing saga of Channel 9 (Nine) which has played out in the press was finally resolved. As it revolved largely around the interaction of various debt holders, it makes for an interesting example of the capital structure at work. Here we assess some of the key points of the transaction to see how a company’s capital structure works in the real world, when things go awry.
The background
In 2007, private equity firm CVC Asia Pacific (CVC) effectively bought Nine from James Packer for $5.3bn through a number of transactions. Initially, CVC acquired a 50% interest in PBL Media in September 2007, later increasing its ownership to 75%, giving it effective control of the company. By December 2008, CVC had increased its ownership to 99.9%, in 2010 the company was renamed Nine Entertainment Co.
The initial acquisition was funded by $1.9bn in equity (put up by CVC), and $3.4bn of debt. As we now know, the purchase occurred just prior to the onset of the global financial crisis; CVCs timing could not have been worse.
Whilst some have made the connection to James Packer’s fortunate sale timing to that of his fathers’ sale of the same asset decades earlier to Alan Bond, the reality is the younger Packer used the proceeds to make casino property purchases which were also written down at the onset of the GFC.
With the onset of the GFC, and the slow economic environment which continues to this day, Nine’s primary revenue source, advertising, declined, placing the business under stress. The period also proved difficult from a ratings perspective, further damaging advertising revenues.
Banks get cold feet
With the drop in profitability, Nine’s bankers began to get concerned about the company’s ability to roll over its debt, and in particular nearly $3bn of senior debt maturing in 2013. The company itself was also concerned.
Bankers then began to sell their senior debt at a discount to face value. The banks were prepared to take a loss upfront rather than risk a deeper loss or prolonged liquidation proceedings down the track. CVC also suffered from the change in dynamics in the Australian funding market with many European banks leaving Australia to concentrate on domestic markets given ongoing global economic difficulties.
Hedge funds Apollo Global Management, Oaktree Capital and Orch-Ziff Capital Management were the main purchasers of this debt. These hedge funds seek to buy debt at a discount as a way to gain control of a company without making an equity take over. Once they have secured the debt, they know they are in a strong negotiating position with any company which is facing default.
In November 2011 CVC offered lenders an “amend and extend” proposal, increasing margins to 400bps over swap and a 75bps fee if they agreed to extend maturity to 2015 for senior debt and 2016 for mezzanine debt. CVC dropped this proposal a month later, and the hedge funds began to push for restructuring negotiations.
CVC, attempted a second solution for its maturing debt by proposing to split senior debt into two tranches: $1.8bn of senior debt maturing in 2017 and $900m in high yield (14%) warrants on a ‘pay if you can’ basis. This proposal was again rejected by the senior lenders.
By this stage, the hedge funds are well aware of the strength of the hand they held as it had become increasingly apparent that CVC would be unable to refinance their debt at maturity and Apollo Global Management continued to strengthen their position by buying up more senior debt from various banks. By the end of 2011 hedge funds reportedly owned around half of the senior debt of Nine and begin a full blown assault on CVC to convert debt to equity. Any such conversion would have significantly diluted CVC’s position and as such CVC rejected any restructuring plan.
The final throws
The advertising market continued to deteriorate throughout 2011 and 2012. Consumers keep their hands in their pockets and discretionary spending across Australia dropped. This continued to place negative pressure on Nine’s performance at the same time as CVC was seeking a refinancing solution. By early 2012 virtually none of the original bank holders of Nine’s senior debt remained, with the hedge funds now the lenders to Nine.
The hedge funds now owned the majority of $2.8bn in senior debt of Nine, reportedly purchasing the debt at discounts between 15-35% from the original lenders. Goldman Sachs owned around 20% of the $975m in mezzanine (lower ranked) debt directly, with the rest held on behalf of its flagship mezzanine debt funds. Goldman’s had reportedly already written down this investment to $200m (or around 20c in the dollar) at this stage.
In March 2012, CVC began a road show in the US and UK to test investor appetite for the refinancing of Nine’s senior debt (which was still set to mature in 2013). The road show was in part driven by a deal CVC had struck with Goldman’s who were seeking to convert the mezzanine debt to equity, if CVC could refinance the senior debt.
This is not an uncommon action for junior debt holders as they seek to see some return, knowing full well the senior debt holders will take control if the company goes into liquidation. Effectively, getting some value through equity is better than getting no value through the mezzanine debt. This proposal may in some instances prove attractive to potential senior debt refinancers as it decreases the overall debt burden of the company. However, by this stage, the performance of Nine, and its subsequent value had dropped significantly. It was largely viewed that the value of the company was less than that of the senior debt, so the road show was doomed to fail.
In an attempt to do something, anything, to save their investment, CVC sold off ACP Magazines (a successful business in its own right) to German publisher Bauer Media for $525m. It was the final act of CVC.
The outcome
With no chance of refinancing the senior debt, the hedge funds took effective control of the negotiations. A debt for equity swap was negotiated with the senior debt holders taking the lion’s share of Nine. The $2.8bn (face value) senior and $1bn mezzanine debt was swapped for equity valuing the company at $2.34bn. Nine, valued at $5.3bn when CVC entered the picture in 2007 was worth less than half five years later.
CVC’s $1.9bn equity investment in Nine is now worth less than $10m. It is not clear to me why they even receive $10m, but regardless, this represents a return of 0.5c in the dollar for their five year investment, and is the largest write-off in CVC Asia Pacific’s history.
The mezzanine debt holders receive $103.5m in equity, around 4.5% of the new business and significantly less than the $400m that Goldman’s had been seeking.
The hedge funds (and the remaining original bank lenders) as the senior debt holders get the best deal, securing 95.5% of the new, debt free business, taking control of Nine.
The debt for equity swap is the forth large deal of this kind in the last two years. Other similar deals also driven in part by the extended fallout of the GFC and the years leading up to it include: Alinta Energy, Centro Property radiology company I-Med.
The lessons
We often talk about the capital structure here at FIIG and the importance of understanding it when making investment decisions. As we say, the higher up the capital structure you are, the more protection you enjoy, and this is borne out in the example of Nine.
Whilst all the original participants in the deal (senior bankers, the mezzanine debt holders, and the equity holders) have taken losses due to the decrease in value of the business (and perhaps the over-exuberant original valuation of the company) it none-the-less shows the value of being higher up the capital structure. Based on the final return, versus original face value, the senior lenders received 80% of the value of the transaction, whilst the mezzanine debt holders earned 10% and the equity holders around half of 1%. Of course, the hedge funds purchased the senior debt at a discount to face, so they have had a more than successful sojourn into the Australian media landscape.
It is not just the return on investment where the investors higher up the capital structure have the advantage. Certainly, for the last 12 months, the senior debt holders (the hedge funds) have been the driving force in all negotiations as the other participants knew they had the strongest position. The senior bond holders will always look after themselves.
This of course raises the question, why did the senior bond holders ‘give’ anything to the mezzanine holders at all? The most logical answer is to stave off liquidation. Whilst senior holders would be most protected if Nine fell into liquidation, there are commercial implications beyond this which allowed Goldman’s to place at least a little pressure at the negotiating table. The main commercial implication for Nine’s lenders/new owners is the sanctity of contracts in liquidation.
It is often reported that when a company goes into liquidation that employee contracts can become null and void; this is also the case for many commercial contracts. Significant value in Channel 9 arises from its long term sport broadcasting contracts, cricket, and the recent renegotiated rugby league television rights. The senior lenders, as the potential effective new owners, would not want to risk seeing these contracts back on the open market.
To avoid the chance of these contracts going back to the open market, the senior lenders were prepared to give up some value to the mezzanine lenders, but the negotiations were certainly on their terms.
Going forward
So what now for Channel 9? Whilst Nine boss David Gyngell emerged from the negotiations with a smile on his face and his reputation intact, it’s perhaps a little early for the popping of corks.
Whilst Gyngell noted that Nine is in a strong position going forward, with no debt on the balance sheet and better recent performances in the ratings, headwinds remain. Hedge funds now own Nine, and while there may be no debt currently on the balance sheet, this is unlikely to be the case for long. The hedge funds will already be looking at their next deal, which will require them to get cash out of this deal. They will do this by raising debt; it will be far less debt than was previously in the structure, but the quickest way for the hedge funds to see cash is to start by putting debt into the company.
Commercial television remains a tough business. Channel 10 last week announced significant cuts across the company. Nine’s value has halved in the last five years; I expect there will be significant cuts at Nine as well.
In the medium to long term, hedge funds will not want to own Channel 9, so they will most likely look to list the company down the track. To do this, and to maximise their returns, they need to make it look attractive, they can do this by improving profitability. With advertising rates and the general economy remaining challenging, the easiest way (and perhaps the only way) to improve profitability is to cut costs. Marginally profitable shows, high paid on-air talent and state based programming are likely to come under the microscope. Expect to see more re-runs of Two and a Half Men.
Note: By their nature, the negotiations and deals struck throughout this process are private in nature. This review is based purely on publically available information and reports from Bloomberg. The principles of how the capital structure worked in this situation would however stand true, regardless if the reporting of actual dollar amounts may differ from the actual amount.