Read the Risk Factors First
I have been asked by clients over the years how to best read an offering memorandum for optimal analysis of risk. Should they start in the summary box at the beginning of the OM? Or flip straight to the Description of Notes and slog through this summary of the covenants?
The challenges facing Credit Suisse AT1 bondholders illustrates well why my answer is always the same, regardless of the borrower in question: start by reading the Risk Factors.
This is a vastly underappreciated section of the prospectus that was once described to me in my baby lawyer days as “management’s insurance policy”, or slightly more cynically, “where the bodies are buried”. It lays out every material risk the lawyers could think of that might impact bondholders’ ability to get paid coupon and principal at maturity.
As a result, the Risk Factors section contains a treasure trove of information and – importantly – it is written in plain English (in contrast to the Description of Notes, which is written in legalese).
Yes, they are a bit in the vein of chicken little, and if taken literally would dissuade most rational investors from handing over large sums of money. But viewed more as a roadmap to risk, they can be very useful.
Guarantor coverage and local law limitations; total outstanding debt, including the quanta of senior, pari passu, and junior ranking debt; and intercreditor provisions on enforcement instructions (among other things) are all clearly set out in this section.
Not only that, but some covenant features may be highlighted here – the presence of a portability exception to the Change of Control covenant, for example, or in the case of CS’s AT1 notes, whether and when a viability event might permit the regulator to write down the notes.
Investors who start their analysis at the Risk Factors section will have a powerful lens through which to view the potential downside risk in the issuer’s business, industry, capital structure, and covenants.
Students in our Leveraged Finance Covenant Training know the value of reading the Risk Factors. We show them how disclosure in this section can help guide the rest of their analysis, which will include a review of other key sections of the prospectus and discussions with management (top tip: ask questions!).
Ultimately, an effective analysis of downside risk requires investors to be fluent in two languages – English and legalese – and to knowhow to find where the bodies are buried.
By Sabrina Fox