Navigating the energy sector has been a difficult exercise in the first two months of 2013 due to activist investors. AAM remains mindful of the trend of levering the balance sheet to increase shareholder returns, which makes a thoughtful and careful approach to security selection an imperative. Closely monitoring metrics such as shareholder returns, enterprise value and debt capacity have allowed us to identify “at risk” credits. However, being nimble and taking advantage of opportunities provided during periods of weakness should afford superior excess returns.
It has been an anxious February for investors in several energy credits due to activist shareholders. This issue continues to be a risk with which we are concerned. In the AAM 2012 Sector Review and 2013 Outlook (AAM 2012 Sector Review and 2013 Outlook), we noted “the trend of levering the balance sheet to increase shareholder return will continue, and security selection will be a greater contribution to returns in 2013.” Below, we describe how this risk affected excess returns in the energy sector in January and February, the steps we are taking to avoid private equity targets, and the additional measures of protection we are seeking in this environment.
For the first three weeks of 2013, the energy sector was enjoying a good run: Macondo oil spill litigation was nearing an end, several governmental antagonists in the U.S. had resigned their positions and oil prices remained strong. Excess returns through January 22, 2013 were a positive 23 basis points for Energy, only slightly behind the positive 28 basis points for Industrials.
Activist Investors Negatively Affect Excess Returns in the Energy Sector
In the third week of January, the positive sentiment turned negative overnight. Within four business days, three different activist shareholders (Pamplona Capital Management LLP, Carl Icahn and Elliott Associates, L.P.) announced they had accumulated large positions in three distinct companies (Nabors Industries, Transocean Ltd. and Hess Corp., respectively). All three activists provided bondholder unfriendly methods to improve returns. Other energy credits that the market deemed vulnerable to a shareholder friendly event, including Devon Energy and Weatherford International, were also negatively affected. Combined, these five credits are responsible for nearly 15% of the market value of the energy component of the Barclays U.S. Aggregate Index and contribute nearly 23% of this sector’s OAS. Exhibit 1 depicts how the shareholders’ threats have affected the 10-year bonds’ performance over the past month. As a result of this tumultuous four day period at the end of January, the energy component of the Barclays U.S. Aggregate Index under-performed Industrials by 39 basis points.
The Steps We Are Taking to Avoid a Significantly Negative Credit Event
Since the second half of 2012, the low cost of capital and the reduced volatility in the credit market have contributed to an environment particularly ripe for shareholder friendly actions. Because of this environment, we have been employing different filters to help us pare back on higher risk candidates and to avoid potentially vulnerable new credits. Factors that we are monitoring closely on a daily basis include: latest twelve month equity returns, enterprise value, existing leverage and asset sale potential.
The first item we monitor to identify potential leveraging candidates is the latest twelve month equity returns. If the equity return for a credit is substantially below its peers and a broader index, all else being equal, the probability that a shareholder friendly event will take place in the near term is above average.
Secondly, we monitor the amount of debt and available debt capacity a credit has. If a company currently is under-levered relative to its investment grade peers, debt can be added to the balance sheet to fund a special dividend or substantial share repurchase. Therefore, if the credit has a weak latest twelve month equity performance and available debt capacity, the chances of a shareholder friendly event are more than likely.
We also continually analyze the credit’s enterprise value, particularly if its equity is underperforming and it has capacity to add debt. Given the recent Dell Inc. and H.J. Heinz Co. transactions, $20 billion appears to be the maximum leverage buyout amount that the capital markets could currently digest given the state of the bank loan and high yield bond market. Given those market conditions, if the enterprise value of an energy company is substantially below $20 billion, its LTM equity performance is well below its peers, and it has the capacity to add substantial debt, there is above average risk that a shareholder friendly could take place in the near term.
We pay particularly close attention to those credits that clear the first three hurdles and that have any under-utilized assets that could be monetized. If a company has under-utilized assets (e.g., non-core acreage, pipes or older rigs), which a company could monetize to fund a shareholder friendly action, this presents problems for bondholders. After all, if a company funded the purchase of those assets with a combination of equity and credit, yet the proceeds from the sale of that asset are used only to the shareholders’ benefit, that weakens the overall risk profile of the credit. We think Nabors’ and Hess’ bondholders are particularly vulnerable to this scenario. The most at risk candidates in the energy sector using these filters are listed in Exhibit 2.
|At Risk Energy Credits|
|Hess (if not for its 12% return subsequent to Elliot)|
Sound Credit Selection, Being Nimble and Strong Covenants Should Provide Outperformance
We believe there are two key factors to outperforming in the energy sector in the remainder of the year. The first step will be to avoid bonds that fall victim to shareholder friendly actions and thereby prevent months like January, where the sector underperformed industrials by 39 basis points. Secondly, investors will have to smartly take advantage of the buying opportunity of issues unfairly penalized for being in the same sector. Investors that succeed in this effort will achieve results like February, when excess returns for the energy sector exceeded industrials by 20 basis points. However, when we buy issues from energy companies in this apprehensive environment, one additional item we will be seeking is relatively strong covenants.
Of particular interest to us are bonds that contain limitation of liens and change of control covenants. The limitation on liens covenant (also known as a springing lien covenant) protects existing bondholders in the event that a company uses a meaningful amount (generally more than 10% of company’s assets) of senior secured debt to fund a transaction. For example, several years ago Carl Icahn persuaded Kerr-McGee to use the proceeds from $4 billion of senior secured leveraged loans to repurchase stock. The outstanding debt of Kerr-McGee had springing lien, and since the $4 billion of secured leveraged loans issued exceeded the allowed amount under the existing debt covenant, the existing debt became secured and pari passu (on equal footing) with the new secured leveraged loans.
Offering more protection for the bondholder is the change of control put (the option to sell). This covenant is very beneficial, especially for bonds trading near par, as it mitigates downside risk in a very substantial shareholder friendly event, such as a leveraged buyout. In the event of a change of control, bondholders have the right to put the bonds at $101.
This change of control put at $101 clearly is more beneficial for the more recently issued bonds that still trade near par (downside is limited to purchase price minus $101) versus older bonds that are likely trading considerably greater than par. As a result, all else being equal, we would prefer to own a bond with change of control language near par in this environment. Exhibit 3 below is a list of the at-risk issuers discussed earlier with their covenant details.
|At Risk Energy Credits||10 Yr Bond||COC (Y/N)||Springing Lien (Y/N)|
|Encana Corp.||$105.18||N||Y; 10% CNTA|
|Murphy Oil||$98.78||N||Y; 10% CNTA|
|Nabors Industries||$103.92||Y, $101||Y; 10% CNTA|
|Rowan Companies||$109.71||N||Y; 15% CNTA|
COC=Change of Control, CNTA= Consolidated Net Tangible Assets. Source: AAM, Bloomberg
A pillar of AAM’s 2013 Corporate Outlook is that a strong focus on individual credit selection and remaining nimble to take advantage of market opportunities as they arise will be keys to a successful year. That idea has certainly played out in the first two months of the year in the energy sector. A relatively mundane beginning of the year gave way to activist investors in the last week of January causing excess returns from the energy sector to lag industrials by 39 basis points. Those investors that took advantage of this weakness were rewarded in February by outperforming industrials by 20 basis points. Throughout the second half of 2012, AAM reduced exposure to energy credits susceptible to private equity investors and will continue to seek out opportunities, especially those with better than average covenant protection.
Written by: Patrick McGeever, Senior Analyst, Corporate Credit
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns. This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.