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Allergan Implodes: Pfizer Deal In Jeopardy After Treasury Announces “Action To Curb Inversions, Earnings Stripping”

05.04.2016 Tyler Durden 0

As if a million M&A arbs suddenly cried out in terror, and were suddenly silenced.


Moments ago the stock of Allergan imploded, crashing by 20%, plunging to $225 or the lowest level since late 2014, in the process blowing up countless M&A arb deals which were hoping the recently blowing out spread, which as of Friday hit a post announcement wide of $61, is attractive enough to take the risk of a Treasury crackdown on tax inversion deal.

Alternatively, maybe someone knew something.

Something, such as what the Treasury announced 5pm this afternoon in a release titled “Treasury Announces Additional Action to Curb Inversions, Address Earnings Stripping

As the title implies, the Treasury has just made it quite clear that any and all tax inversions, of which the Pfizer-Allergan deal is most notable, are no longer welcome. This is what it said.

Treasury Announces Additional Action to Curb Inversions, Address Earnings Stripping


Today, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued temporary and proposed regulations to further reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping. By undertaking an inversion transaction, companies move their tax residence overseas to avoid U.S. taxes without making significant changes in their business operations. After an inversion, many of these companies continue to take advantage of the benefits of being based in the United States, while shifting a greater tax burden to other businesses and American families.


Treasury has taken action twice to make it harder for companies to invert. These actions took away some of the economic benefits of inverting and helped slow the pace of these transactions, but we know companies will continue to seek new and creative ways to relocate their tax residence to avoid paying taxes here at home,” said Treasury Secretary Jacob J. Lew. “Today, we are announcing additional actions to further rein in inversions and reduce the ability of companies to avoid taxes through earnings stripping. This will have an important effect, but we cannot stop these transactions without new legislation. I urge Congress to move forward with anti-inversion legislation this year. Ultimately, the best way to address inversions is to reform our business tax system, which is why Treasury is releasing an updated framework on business tax reform, outlining the administration’s proposals to date as a guide for future reform. While that work goes on, Congress should not wait to act as inversions continue to erode our tax base.”


Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States. But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of a parent entity to a low-tax jurisdiction simply to avoid U.S. taxes.


Today, Treasury is taking action to:

  • Limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. This will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition.
  • Address earnings stripping by:
    • Targeting transactions that generate large interest deductions by simply increasing related-party debt without financing new investment in the United States.
    • Allowing the IRS on audit to divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other.
    • Facilitating improved due diligence and compliance by requiring certain large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt.  If these requirements are not met, instruments will be treated as equity for tax purposes.
    • Formalize Treasury’s two previous actions in September 2014 and November 2015.

 Treasury will continue to explore additional ways to address inversions.
Treasury is also releasing an updated framework for business tax reform, which revises the framework released in 2012. This lays out the key elements of the President’s approach to reform and details the specific proposals the administration has put forward, including a comprehensive approach to reforming the international tax system.

The Allergan-Pfizer spread now is basically to levels as if the deal never happened:


We can’t wait to find out how many M&A arbs, who had anywhere between 2x and 5x (or more) leverage on the arb spread (of which the most notable recent arb chaser is none other than Franklin resources whose Dec 31. $1.3BN pure arb stake is now worth 20% less in an instant) just blew up after hours with just this one simple press release.

We also wonder how this will impact the broader, and quite illiquid, market tomorrow.

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The Inevitable Failure Of The War On Cash

05.04.2016 Tyler Durden 0

Submitted by Jeff Thomas via, Some years ago, when I suspected there would be a War on Cash at some point, everything in the behaviour of the central banks pointed to the idea—it fit exactly into their own informed, yet unrea…

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Valeant Tumbles As Lenders Demand Two Pounds Of Flesh For Covenant Waivers

05.04.2016 Tyler Durden 0

Two weeks ago, the catalyst that pushed Valeant CDS to record wide levels implying a 55% probability of default over 5 years, while sending the company’s stock plunging, was news that Valeant was scrambling to engage its lenders to obtain a default waiver to its bank credit agreement to eliminate a technical default that arose when it didn’t file its 10-K before March 15.

As we reported then, “in anticipation of those meetings, owners of Valeant’s senior bank loans are reaching out to investment banks, including Barclays, who will help mediate the negotiations, the sources said. Barclays did not immediately respond for comment.”    

As was explicitly warned, the lenders’ demands include higher interest payments and a pledge to pay a larger amount of the bank loans from the proceeds of any Valeant asset sales.

Since then the stock bounced modestly because apparently the algos forgot that when lenders smell blood and a potential default from a debtor without any other recourse, they will demand a pound of flesh. Or maybe two.

Well, moments ago the market got a harsh reminder that Valeant is effectively negotiating default compliance with a group of banks who realize they are dealing with a company that has a $9 billion market cap and can thus ask for anything and management and shareholders have no choice but to say yes unless that $9 billion to quickly go to $0.

According to Bloomberg, Valeant, just as predicted,  “is facing push back from some of its lenders as it seeks to waive a default and loosen restrictions on its debt, according to people with knowledge of the matter.”

The resistance may complicate Valeant’s efforts to win the support it needs before the Wednesday deadline for lenders to respond. The company, which has about $32 billion in total debt, must gain approval from more than half of the investors holding its more than $11 billion of secured loans. Those that are balking are demanding a higher interest rate and a better fee, said the people, who asked not to be identified because the discussions are private. They also want to impose some restrictions on the terms the company is offering on the proposal, they said.

Also known as a pound of flesh. Or maybe two.

Bloomberg reports that the initial Valeant “bid” is a 50 basis-point fee and a 0.5 percentage point boost on the interest it pays on its term loans, people with knowledge of the matter said at the time.  Banks, however, want more: “Some lenders might see it as an opportunity to extract better pricing or other terms,” Justin Forlenza, an analyst at independent credit-research firm Covenant Review, said in an interview. “They can meet at a certain point that lenders and the company can get comfortable with.”

Now this is only for the default waiver. Additionally, as a result of its collapsing business Valeant has to cure a key negative covenant limiting its interest coverage ratio to just 2.25x. Valeant’s coverage is about to jump to at least 3.00x and here again the banks want moar.

Under the current proposal, the drug maker is also seeking to loosen restrictions on its credit pact that govern a measure of earnings the company needs to maintain relative to its annual interest expense, Valeant said in a statement on March 30. The interest-coverage ratio was set to jump to three times from 2.25 times, with that level set to be tested before the end of June, according to its current agreement with lenders.


Asking lenders to relax loan covenants suggests Valeant may not be able to repay debt as quickly or generate projected earnings, according to Bloomberg Intelligence analyst Elizabeth Krutoholow.

The good news for the banks is that Valeant still has lots of spare cash to pay out, and more importantly zero leverage. And since there are virtually no recent comps for such covenant waiver deals, the banks know that they can demand anything they want and will get it, since management has no choice but to concede to any demand, as the alternative is an outright default and complete collapse in the equity value of the company.

This perhaps explains why after jumping into the $30 range last week, VRX stock is once again back just north of its multi year lows.

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One Junk Bond Analyst’s Catastrophic Forecast For What Is Coming

05.04.2016 Tyler Durden 0

“cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before”

     – BofA High Yield strategist Michael Contopoulos


While not as quixotic as Morgan Stanley’s Adam Parker piece on market-chasing cockroaches, BofA high yield analyst Michael Contopoulos has moved beyond merely bearish and is now outright catastrophic . That may be a little far fetched, but in his latest note – while he doesn’t call rally chasers “cockroaches” (yet), he seems at a loss to explain the ongoing junk bond rally. His reasoning: fundamentals just keep getting worse by the day, while price action has completely disconnected from reality, and virtually nobody expects what is about to unfold in the junk bond space.

First, according to his assessment of deteriorating macro and micro indicators, the recent price move makes little sense:

Despite the strong payroll data the economy still appears to be headed in the wrong direction, as our economist’s tracking model now indicates just 0.6% Q1 GDP growth and a revised 2.0% (from 2.3%) for Q2. Should our team’s figures hold, the period ending March 31st will mark the 3rd consecutive quarterly decline in GDP and the second sub 1% quarter in the last 5. More importantly for high yield investors, however, is that earnings growth continues to be anemic. 2 weeks ago we wrote that too much emphasis has been placed on Adjusted EBITDA, an approximation of cash flow that doesn’t take into account “1-off” charges, working capital, capex, etc. Although we understand the allure of this measure, in our eyes it has the tendency to cover up late cycle problems; namely asset impairments. With the understanding, however, that this measure is likely to be used for some time to come, we highlight the following: Even with 1-off adjustments 6 out of 17 sectors realized negative year-over-year Adjusted EBITDA in Q4, with a 7th sector growing at just 0.5%. On an unadjusted basis, 9 sectors realized negative EBITDA growth for Q4.



Because one quarter doesn’t tell the whole picture of a company’s earnings momentum, we also calculated both Adjusted and Unadjusted EBITDA by weighting the last 5 quarters 30%, 25%, 20%, 15,%, 10% (Q4 2015 having the highest weight Q4 2014 the lowest). What we find is that the commodities sectors are clearly not the only industries to be experiencing troubles as Capital Good, Commercial Services, Consumer Products, Gaming, Media, Retail, Technology and Utilities are all under pressure. Additionally, on an unadjusted basis Healthcare also doesn’t look like the darling some firm’s spreads would suggest.

Then he looks at where in the credit cycle the market currently finds itself:

We’ve written on multiple occasions how the main question mark surrounding the end of this credit cycle is its shape, not whether we’re currently living through it. As mentioned above, fundamentals have been consistently deteriorating even outside of commodities, defaults are rising, new credit creation is becoming difficult, and illiquidity is still a problem. Although technical tailwinds in the form of retail inflows and supportive central bank policies can prolong the market unwind, they do not change its direction as ultimately fundamentals will prevail.

That is a bold assumption with every central bank having become an activist, but yes: ultimately fundamentals will prevail.

In terms of the shape of this cycle, absent a recession we expect the pace of defaults to be much closer to the 1998 experience than the 2007 one. In fact, we have coined the phrase “a rolling blackout” to describe the potential for a period of many years where the market experiences general weakness and moderately high defaults as individual sectors take turns realizing their moment of distress. Whether these moments are based on a deterioration of underlying fundamentals, an unwind of crowded trades, or some sort of series of macro-economic incidents is nearly irrelevant, as the uncertainty and consistent underperformance of the overall market will likely frustrate many investors and asset allocators. In our view this is not unlike the 1998-2002 experience, where the very same scenario could played out: years of high yield underperformance, poor returns and moderately high defaults. Recall in those years, high yield returned 2.9%, 2.5%, -5%, 4.4%, -1.9% (and 3 years in a row of negative excess returns) while the default rate slowly crept up from 2% to 8% over the course of 3.5 years before hitting double digits.

Next, he proceeds to the “apocalyptic part”, stating quite clearly that “the losses over the credit cycle could be worse than we’ve ever seen before.” One reason: central bank intervention that keeps kicking the can instead of allowing the disastrous fundamentals to finally reveal themselves.

Should the market realize a mid to high single digit default rate for years cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before. A total of 33% of issuers defaulted over the course of the 1987 and 1999 default cycles, higher than the 25% in 2008 as the latter benefitted from unprecedented central bank intervention. But the very same policies which helped alleviate the pain in the last cycle will likely add to the severity of the next one. This is because many of the companies that should have defaulted 7 years ago but instead received a lifeline will likely shutter doors now. As risk premiums have caused yields to jump nearly 400bp, many of these firm’s business models will now likely be unsustainable; especially given the lack of EBITDA growth we have seen this cycle (Chart 1). When these issuers are then coupled with the newest crop of unsustainable businesses from this credit cycle, we could see cumulative default rates approaching 40% this cycle versus the traditional 33%.



It’s not just the upcoming surge defaults. Contopoulos also e focuses on product-specific issues which we have discussed before, namely the already record low recovery rates, a unique feature of this particular default cycle. These are only going to get worse.

However, not only will defaults be higher than in past cycles, but credit losses are also likely to be worse than ever before. That’s because recoveries, even outside of the commodity space have been paltry in the post crisis years. Given where we are in the default cycle, prevailing recoveries are a full 10 points lower than where they should be. Chart 2 highlights historical time periods characterized by low default rates (inside of 4%). Whereas in the past, recoveries tended to surpass 50% in low default environments, the last few years have seen those averaging 40%. This is telling because it means the pressure on recoveries is not being caused by the abundance of assets for sale in the market, which increases as more companies default, but rather because of the quality of these assets as we have discussed in part 1 of our recovery analysis published last year.


One reason for the collapse in recovery rates: the extensively documented chronic underinvestment in replenishing the asset base, and instead “investing” in buybacks and dividends.

So why are today’s assets garnering less enthusiasm than before? One reason, of course, is that a large portion of defaults today are in the commodity space, which are finishing with sub 10% recoveries as investors try to grapple with a market which may not have hit its bottom. However, problems persist even outside of the commodity industries. Take a look at the YoY growth in capex for non-commodity HY issuers (Chart 3). It’s striking how CEOs have invested much less in their businesses this cycle compared to previous ones. In fact, most of the capex growth since 2010 has come from energy issuers on the back of the US energy independence story in the early part of the decade; and we all know not to count on that going forward. On top of that, asset impairments as a percentage of tangible assets are through the roof, chipping away at valuations of an already low asset base. Not surprisingly, non-commodity recoveries reflect the same extent of erosion post 2010 as does overall HY (Chart 4).

If that wasn’t bad enough, it gets worse: “Given that HY companies have seen hardly any organic growth within last few years, it is of little surprise that recoveries today are so low. The bad news is that we think they are going to decline further.”

Contopoulos then analyzes various fundamental trends to determine the shape of the upcoming default cycle, and concludes with the following bleak assessment:

So where does this leave us? According to our model, should the default cycle look similar to the 1999 experience (2yr cumulative DR of 25%), and debt-to-asset ratio touch the highs of that cycle (0.51x), recoveries can be as low as 16c on the dollar. There is also a case to made that if there is no catalyst to total capitulation, and we see a longer flatter default cycle, we could see 2yr cumulative default rates much less than 25%. While this is reasonable, one can also argue that debt-to-asset ratio which today already stands at 0.48x, could ultimately go much further past 0.51x. Additionally, as we have seen in the post crisis years, default rates matter less than debt-to-asset ratios, meaning recoveries even under a rolling blackout scenario could even be worse than we expect.



Table 3 presents a scenario analysis of the range of recoveries to expect in the next few years depending on one’s forecast of default rates and debt-to-asset ratios. In almost any scenario recovery rates stand to be well below 30% this cycle.

According to Contopoulos, investors are only slowly starting to appreciate just how bad the future will be for junk bond investors:

While most investors we have talked to appreciate that recoveries will be lower going forward, we think it’s just as important to highlight just how much. Because, 8% yield may sound attractive if your expected credit losses are 400bps (6% DR*70% LGD). But the picture suddenly becomes unappealing knowing these losses could accumulate to 500bps; suddenly leaving you with an unremarkable excess spread cushion.


And it appears that investors have begun to pay attention, at least as seen from the events in the primary market. It’s no surprise that CCC issuance has cratered in the last year as investors are unwilling to extend credit to low quality issuers. Now it seems they are even rewarding BB issuers for using their newly raised debt judiciously, as can be seen from the lower clearing yields for debt being earmarked for capex investment over anything else

Welcome to the brave new world of massive default losses and record low recoveries.

This new world will be one where investors should and will adjust their expected compensation higher to make up for rising defaults, dwindling recoveries, and declining liquidity, all of which are here to stay.

Come to think of it, we almost prefer Adam Parker’s incoherent ramblings about cockroaches better: at least it gave some sense that there could be a happy ending. If only for the cockroaches that is….