Wednesday, 5 May 2010

No David Gill, the bond issue is NOT "like remortgaging your house"

As David Gill hasn’t made many public statements about the club’s financial position since the bond issue, I always look out for his comments with interest.  On Sunday the News of the World and various other media outlets reported David’s comments in the latest edition of the Manchester United Disabled Supporters Association magazine “Rollin’ Reds”.  This is what he was quoted as saying about the debt:

"In essence, it changed third-party bank debt with various maturities into new debt, so it was like remortgaging your house with what we feel is a better instrument.
"There are no covenants if you meet interest payments every quarter - you are very much left to your own devices.
"So while debt is obviously on the minds of the supporters the simple answer is while we didn't reduce overall debt we now have more flexibility with what we believe is a better instrument and the bond issue attracted roughly double the target, so in that sense it was a success."

Doesn’t that sound reassuring?  It’s just like switching your mortgage to get a better deal....  Well here’s a question, how many people move their mortgage to a lender who charges them more interest than they were paying before?  Because that’s what Red Football has done by switching the bank debt for the bonds.

Let me explain....

The cheap bank debt
This is how the old bank loans were described in note 17 of Red Footballs accounts for the year to June 2009:

£501,707,000 of senior facilities drawn down by Red Football Limited, by way of four term loans that attract interest based on LlBOR plus a margin which ranges between 2.125% and 5.00%.
The senior facilities have terms between 7 and 10 years from the 16 August 2006, and the term loans have an average life of 5.6 years at the balance sheet date. Term loan A accrues interest at LIBOR + 2.125% and amortises over its term with a final re-payment in June 2013. Term loan B accrues interest at LIBOR + 2.5% and is repayable in two equal instalments in February 2014 and August 2014. Term loan C accrues interest at LIBOR + 2.75% and is repayable in two equal instalments in February 2015 and August 2015. Term loan D accrues interest at LIBOR + 5.0% and is repayable in one instalment in August 2016. The above loans are redeemable at par.
What’s missing from that description is how much each term loan was.  This document (the “term sheet” for the loans from 2006) tells us how much they each were in 2006, since when Term Loan A has been gradually paid down to bring the total to £501m:

Term loan
“Margin” over LIBOR

The “margin”, is the extra interest charged above “LIBOR” which is the “London Interbank Offered Rate”, a benchmark wholesale interest rate.  Because LIBOR goes up and down with market interest rates, the actual rates charged on these loans will fluctuate over time.  LIBOR today (6 month LIBOR) is 0.94%.  So the interest rate on these facilities if they were in place today would be 3.482% + 0.94% = 4.422%.  On £501.7m of debt, that would cost £22m a year in interest.

The expensive swap
At this point, regular followers of United’s financial affairs are probably thinking something like: “What the hell are you talking about Anders?  The interest charge shown in last year’s accounts was over £40m....” and they’d be right too.  The interest payable on bank loans and overdrafts in the Red Football accounts was £42.1m.  So what’s going on?  The answer is “the swap”.  An interest rate swap is a derivative contract that “swaps” one rate for another.  In the case of Red Football, the company entered into a contract to swap the variable LIBOR element of the bank interest rate for a fixed rate of 5.0775% on £450m of the bank loans.  So instead of paying 3.992% on this £450m, Red Football was paying 3.4282% + 5.0775% = 8.56%.  On the rest of the loans, Red Football paid the lower floating rate.  So half of the interest paid by the club last year was because of the losses on the swap contract.

With the bond in place, Red Football has ditched the swap at a very significant cost.  The swap ran until the end of 2013, and to close it and get rid of it now (as it is losing money) is going to cost £38.6m.  The cost represents the difference between current swap rates (around 2.2%) and the old swap rate of 5.0775% multiplied by the £450m value for three years.  The club is paying £11m of this up front and then around £5m each year for five years.

If the bank debt was still in place, Red Football could still close off the swap at the same cost, and could even lock in the 2.2% available now.  This would fix the annual interest cost at £28.5m per annum.
The very expensive bonds
Unlike the bank debt, the bonds pay a fixed interest rate (or “coupon”).  The coupon on the 425m US$ bonds is 8.375% and the coupon on the 250m £ bonds is 8.5%.  At the current exchange rate, the interest cost of the bonds is £44.8m.  That’s more than twice the interest cost of the bank debt at today’s interest rates.
The real reason for the bond issue
So what on earth is David Gill talking about when he says the bond is “a better instrument” than the bank debt?  United could have exited from the swap (at the same cost), entered into a new swap to lock in current low interest rates, and only have to pay £28.5m in interest a  year vs. £45m on the bonds. The club would also have saved the £15m cost of the bond issue and would only have £500m of bank loans outstanding rather than £534m of bonds outstanding.

So why could the Glazers possibly want to swap cheaper bank debt for more expensive bond debt?  David Gill gives us clues when he says “There are no covenants if you meet interest payments every quarter - you are very much left to your own devices........while we didn't reduce overall debt we now have more flexibility”.

Under the bank debt covenants, 40% of any cash over £1m had to be used to pay down debt and there were strict targets to meet to reduce the ratio of debt to profits each year.  It was very hard for the Glazers to pay themselves dividends under the bank covenants.  You can see all the details in the term sheet.

The bond sweeps away all these restrictions, and brings in all the rights to dividends that I have described elsewhere.  The bond unlocks the Ronaldo money and the early Aon payments.  This cash can now be paid to the Glazers.

So no David, the bond issue isn’t “like remortgaging your house”.  Unless when David Gill remortgages his house he signs up for a higher mortgage rate than he’s already paying and agrees to let a gang of burglars in to steal his silver......