Bond Investors Have a Point in Demerger Spat

It’s a recipe for a good fight. Anonymous bondholders want to squeeze more money from Melrose Industries Plc, the arch cost-cutter of the engineering world known for giving nothing away. This is more than just an entertaining spat: It has implications for how lenders get treated when companies break themselves up — and, in this case at least, the investors have a point.

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The bondholders claim to be sitting on more than 72% of the £130 million ($162 million) of outstanding bonds of Melrose subsidiary GKN Holdings Ltd. At issue is Melrose’s plan to demerge GKN’s auto and powder metallurgy operations, which generate the majority of the unit’s operating profit and revenue. The investors’ argument is that the split counts as a default, thereby obliging GKN to repay bondholders at full face value with accrued interest.

The reasoning is that the bond prospectus’s definitions of default include GKN or one of its principal subsidiaries ceasing “to carry on substantially all of its business operations” — or anything that’s “analogous.”

So far, the group is just protesting against Melrose’s conduct and communications. But it says it’s preparing legal action and has hired Chicago-based law firm Kirkland & Ellis LLP. Melrose has dismissed the claims as nonsense.

It certainly looks like the bond market was unaware any investor protections existed, or didn’t read the covenants so positively. The bonds plummeted when the demerger was announced in September. In November, Melrose made an offer to buy back them back at 87% of face value — a modest premium to their price before the demerger plan was announced. Holders of about £170 million of the bonds accepted.

Mathematically, it’s a stretch to say the demerger jettisons “substantially all” of GKN’s assets. The profit forgone is not even two-thirds, let alone three-quarters, of the total. Where the bondholders appear to have a fighting chance is in claiming that the separation is akin to the demerged assets being shuttered or sold with no compensation. They’ll be transferred to Melrose shareholders and will no longer support the current GKN debt.

It’s not clear which investors are behind all this. M&G Plc, Robeco Luxembourg SA and Invesco Ltd. dominate the latest filings of who owns the debt, but the buyback and subsequent trading will have altered the ownership roster since then. The situation will be a red rag to the more aggressive specialist credit funds.

A common sense reading of the prospectus suggests the bondholders have a case. The pragmatic question on both sides is at what point the costs of fighting exceed those of a compromise. Melrose has a knack for spotting the clearing price in tricky situations; its 2018 hostile bid for GKN narrowly garnered the majority support it needed, with 52% shareholders acceptances. A few million pounds more than the £8 billion Melrose offered would have been wasted, a few million less would have cost Melrose the deal.

The difference between paying face value and the buyback offer price is around £20 million. The snag is that if Melrose caves to the holdouts, it may then open itself up to claims from investors who sold for less in the buyback.

And Melrose has little obvious strategic interest in rolling over to win friends in the bond market. It’s fond of leverage but isn’t a prolific borrower: The instrument in question here was inherited in the GKN deal. Melrose’s real tool is its shares. It buys fixer-uppers and can pay in stock or sell new shares to raise cash. Equity investors have proved supportive.

So it’s little surprise that there’s no settlement in sight right now. Still, if both sides dig in and go to court, it would do the market a favor. A judge could tell us precisely what the ambiguous wording in the covenants really means — and set some clarity for future demerger situations.