Did you notice that in recent quarters, companies have been reporting better EBITDA (Earnings before Interest, Tax, Depreciation & Amortisation) and Free Cashflow figures? Do not be happy too soon, as the improvements could merely be due to a chang…
Category: Boring Investor
Following up from last week’s blog post on Will Temasek Bail Out SIA Bondholders In Event of Default?, here is the analysis on SIA’s 5-year 3.03% bond based on Benjamin Graham’s criteria as described in The Lost Art of Bond Investment. Surprisingl…
As regular readers would know, I stopped blogging for a year. I did not just stopped blogging; I also stopped monitoring performance of my portfolio and analysing shares and bonds in detail. So when SIA launched its retail 3.03% bond in Mar this year, …
|Fig. 1: Azalea Corporate Structure|
|Fig. 1: 3-Year Cashflows of Astrea III|
|Fig. 2: Typical Cashflows of PE Investments|
|Fig. 3: Holding Period of Underlying PE Investments|
|Fig. 4: Astrea III’s Balance Sheets|
Thus, one key risk for bond investors in mature PE funds is when the fund is in the midst of the harvesting period, the sponsor gets most of the money while bond investors get only the interest payment. When the harvesting dries up, bond investors do not get sufficient cashflows to redeem the bonds while the sponsor already gets all its capital back.
Fortunately for Class A (A-1 and A-2) bond holders of Astrea III, there are safeguards in place to ensure that the above scenario does not happen. Every 6 months, Astrea III has to set aside some cash in reserve accounts which can only be used to redeem the Class A bonds. The reserve accounts totalled USD161M, USD224M and USD258M in 2017, 2018 and 2019 respectively. These reserves accounts are sufficient to redeem the Class A-1 bonds which will mature in the next few days. The total amount of Class A-1 bonds is SGD228M (approximately USD170M).
Another safeguard that Astrea III put in place is the Loan-to-Value (LTV) ratio should not exceed certain thresholds ranging from 20% to 45%. If these thresholds were exceeded, Astrea III has to divert more cashflows to the Reserves Accounts. Based on Fig. 4, the LTV ratio of Astrea III is 27%, 18% and 24% in 2017, 2018 and 2019 respectively.
Had there been no such safeguards to set aside cash during the harvesting period, the balance sheet would have been worse for bondholders. Fig. 5 below shows the balance sheet had the reserves accounts been paid out to sponsor.
|Fig. 5: Balance Sheet of Astrea III Excluding Reserves Accounts|
In conclusion, if you are a bond investor in mature PE funds, be prepared to see a shrinking asset base while most of the distributions go to the sponsor. Make sure you have safeguards in place to ensure that a portion of the distributions are set aside for the sole purpose of redeeming the bonds!
|Fig. 1: Lifecycle of PE Fund|
|Fig. 2: PE J-Curve|
|Bond||Wt Age of Fund||Scheduled Call (Yrs)|
|Fig. 3: Lifespan of Astrea Bonds Relative to PE Fund Lifecycle|
Astrea III bonds (blue line) will last from the 6th to 9th year of the underlying PE funds that Astrea III is investing into. This is the sweet spot that we discussed earlier — enter around the 5th year and exit before the 10th year. It is probably the safest of the 3 Astrea bonds. In fact, it has just been announced that this bond would be redeemed as scheduled in 2 weeks’ time.
Astrea IV bonds (purple line) will last from the 7th to 12th year of the underlying PE funds. The PE funds are generating a lot of cash currently, with total net distributions (after deducting capital calls) of USD243M in Astrea IV’s first year of existence. This is equivalent to 22% of its portfolio value at the time of IPO. However, as shown in Fig. 3, the amount of distributions is expected to decline moving forward.
Astrea V bonds (brown line) will last from the 5th to 10th year of the underlying PE funds. Compared to Astrea IV bonds, there is a little more risks initially, as the companies in the PE funds are less mature and less ready to be exited. Furthermore, there are higher capital calls expected. But if these risks in the initial years can be overcome, Astrea V bonds will have less risks towards the end compared to Astrea IV bonds, as cashflows towards the tail-end would not have declined as much.
When you look at the risks of Astrea IV and Astrea V bonds, some of the safeguards that Azalea put in place for the bonds start to make a lot of sense. Let’s talk about Astrea V bonds first, as it is simpler. As mentioned, one of the key risks for it is higher capital calls. This is mitigated by the capital call facility that allows Astrea V to borrow money from the banks to meet the capital calls.
For Astrea IV bonds, the key risk is not receiving sufficient distributions towards the tail-end to redeem the bonds in full. Although there is liquidity facility to meet interest payments in the event of shortfalls in distributions, there is no liquidity facility that Astrea IV can borrow to redeem the bonds. Money to redeem the bonds can only come from the distributions from the underlying PE funds. However, towards the tail-end, such distributions are declining and might not be sufficient to redeem the SGD242M bonds in full.
In fact, it would be unfair to bondholders if it were to happen considering that in the initial years of the bond, the underlying PE funds are generating a lot of cash, most of which are passed through to the sponsor. For the first year of Astrea IV, out of total net distributions of USD243M, all classes of bondholders (Class A-1, A-2 and B) were paid only USD26M in interest. Other expenses during the same period totalled USD7M. If there were no safeguards in place, the remaining USD210M (equivalent to 86% of net distribution of USD243M) and another USD15M in existing cash would flow to the sponsor. This money can leave Astrea IV as dividends to shareholder and repayment of shareholder loans instead of being retained within Astrea IV. Once the money leaves Astrea IV, bondholders have no recourse to Azalea as the shareholder/ sponsor to redeem the bonds in full. Recall that the bond is not guaranteed by either Azalea, or its parent, Temasek?
To prevent this from happening, Azalea has put in place a safeguard that part of the distributions have to be set aside in reserves accounts for the sole purpose of redeeming the bonds. For the first year of Astrea IV, a total of USD80M has been set aside. Hence, the distributions flowing to the sponsor is reduced to USD145M instead of USD225M. This ensures that there will be sufficient cash to redeem the bonds when they mature, even though distributions from the underlying PE funds are declining.
In conclusion, PE bonds are not a simple matter of buy-and-forget. Investors need to understand where they stand along the lifecycle of PE funds and also what investor protection they have. Azalea has done a good job protecting investors from losses, but investors still need to protect themselves by learning more about PE investments.
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