Sunday 7 July 2019

Are Private Equity Bonds Better Than Corporate Bonds?

When Astrea V 3.85% bond was launched, some investors remarked that it is better than some of the recently issued corporate bonds, such as SIA 3.03% bonds. What are the differences between Private Equity (PE) bonds and corporate bonds, and are PE bonds really better than corporate bonds?

It is difficult to compare Astrea bonds with, say, SIA bonds, since their nature of business are different. To make the comparison between PE bonds and corporate bonds more meaningful, let us consider a hypothetical bond issued by Azalea Asset Management, which is the sponsor of the Astrea III/IV/V bonds. Fig. 1 below shows the corporate structure of Azalea.

Fig. 1: Azalea Corporate Structure

The assets of Azalea are the 3 Astrea companies issuing the Astrea III/IV/V bonds and owning the underlying portfolios of PE funds. Azalea probably has some other income-generating assets, such as the investment management company shown in Fig. 1 above, plus some other unlisted PE funds. Thus, the nature of business of Azalea and Astrea III/IV/V companies are similar. What would be the differences between the hypothetical Azalea corporate bond and Astrea III/IV/V PE bonds? Note that the PE bonds are not limited to the Class A-1 bonds which are open to retail investors. There are also Class A-2, B and C bonds.

The first key difference would be the security of the bonds over the assets. Astrea PE bonds are secured against the PE funds in the respective Astrea companies, whereas Azalea corporate bond would be unsecured. In the hypothetical scenario where the Astrea PE bonds default, Astrea bondholders could force the respective Astrea companies to liquidate their PE funds and return money to the bondholders. However, in the event that the liquidation proceeds are insufficient to redeem the bonds, bondholders have no recourse to Azalea, or to the other Astrea companies. For example, if Astrea III bonds were to default, Astrea III bondholders have no rights to the assets of Azalea, Astrea IV and Astrea V companies. The assets of each company are ring-fenced and could only be used to service the bonds issued by the respective company.

Similarly, in the hypothetical scenario where the Azalea corporate bond defaults, Azalea bondholders have no claims over the PE funds held in the 3 Astrea companies. Nevertheless, they could force Azalea to sell off the Astrea companies together with their portfolio of PE funds and PE bonds. However, they could not force Azalea to break up the Astrea companies, sell off their PE funds, redeem the Astrea PE bonds, and return excess cash to Azalea to pay off the corporate bondholders (Note: it might be possible to do so for other project/ asset-level bonds, but the terms of Astrea PE bonds do not allow for early liquidation of assets and redemption of bonds). In other words, regardless of what happens to Azalea, Astrea PE bondholders will not be affected. 

So does it mean that Astrea PE bonds, which are secured against the PE funds of the respective Astrea companies, are better than Azalea corporate bonds which are unsecured? Not necessarily. The key factor is the quality of the assets that are securing the bonds. If the assets are of high quality, the PE bonds have good collaterals. Conversely, if the assets are of low quality, the collaterals would be useless. Remember, Astrea PE bondholders have no recourse to Azalea and the other Astrea companies. They can only count on the assets in their respective Astrea companies to pay interest and redeem the bonds. 

Although Azalea corporate bond is unsecured, if the Astrea companies are generating good cashflows for Azalea, it does not matter whether the bond is secured or not. In a hypothetical scenario where one of the Astrea companies have poor assets whereas the other Astrea companies have good assets, it might be better to hold the unsecured Azalea corporate bond than the secured but troubled Astrea PE bond. So, quality of assets is key in determining whether secured or unsecured bonds are better.

The second difference is that Azalea could have other income-generating assets and businesses besides the 3 Astrea companies. In Fig. 1 above, it has an investment management subsidiary to manage the investments in PE funds for the Astrea companies in return for a fee. It could also have other PE funds that are outside the Astrea companies. So, for Azalea corporate bonds, there could be other sources of operating cashflows, whereas for Astrea PE bonds, the only source of cashflows is the PE funds in the respective Astrea companies.

The third difference is that besides receiving cashflows from the Astrea companies to redeem the Azalea corporate bond, Azalea could refinance the bond through bank borrowings, new corporate bonds, shareholder loans from Temasek, or even private share placements and IPO! Being a corporate bond, there are many avenues to refinance it. Astrea PE bonds do not have such avenues. To reiterate, Astrea PE bondholders can only count on the assets in the respective Astrea companies. If the assets are good, PE bondholders will get the promised returns. If the assets are poor, they will suffer some losses.

Having said the above, being able to borrow money is a double-edged sword. While borrowings could help to refinance the Azalea corporate bond, Azalea could also run the risk of borrowing too much money and jeopardise its ability to pay interest to and/or redeem the Azalea corporate bond if banks decide that Azalea's credit risk is too high. For the Astrea PE bonds, such risks have been mitigated. The terms of Astrea PE bonds prohibit the Astrea companies to borrow money other than to issue the different classes of bonds at inception, as well as to meet capital calls and cover bond interest payment shortfalls. The last 2 conditions are actually safeguards for the PE bondholders (see Understanding the Safeguards of Astrea IV 4.35% Bonds for more info).

In conclusion, PE bonds are not necessarily better or worse than corporate bonds. The key words are: quality of assets securing the PE bonds. This is unlike preference shares and perpetual capital securities, which are inherently inferior to stocks and bonds (see Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form for more info).

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