A New Lift For Small-company Irbs
Last July, Northern TechGas Inc, a newly formed company based in Valley Forge, Pa., set out to acquire the assets and business of an established industrial gas distributor in Wisconsin and to buy some additional machinery and equipment for expansion in the local market. Rather than rely on its own investors or local banks to finance the entire $6.5 million project, the company sought to raise $4 million at the lowest rate possible through industrial revenue bonds (IRBs).
Under normal circumstances, without the advantage of an investment rating on its securities from either Moody's Investors Service or Standard & Poor's, Northern TechGas would have had to peddle the tax-exempt IRBs to a commercial bank and settle for a floating interest rate. But thanks to an innovative twist in taxexempt financing, the company succeeded in placing its 20-year IRBs with one of the nation's major institutions at a fixed rate of 13.25%.
Surprisingly, the investor, Sears, Roebuck & Co.'s Allstate Insurance Co. of Northbrook, Ill., needed to know very little about Northern TechGas. Indeed, since the bond carried a new type of credit insurance designed to make small-issue IRBs marketable to big investors around the country, the investment risk was considered minimal. The insurance, offered by IDBl Managers Inc. of New York City to companies eager to get this type of financing, qualifies IRBs for Standard & Poor's Aaa rating. And while the coverage ended up costing Northern TechGas an eyebrow-raising $300,000 -- 7.5% of the amount it raised through IRBs -- the cost is not extraordinary compared with the alternative: paying a commercial bank rate of two or three points above prime (then 16.5%) on a taxable loan.
Until recently, small companies intercsted in long-term borrowing at the more favorable tax-exempt rates had to be concerned about two big storm clouds overhead. First, the Reagan Administration and congressional critics were lobbying so heavily to eliminate, or at least greatly scale back, IRBs as a financing vehicle for both large and small companies that the future of the mechanism was in doubt. Second, most of the nation's commercial banks -- the principal buyers of small-issue IRBs -- were so saturated with tax-exempt securities that their interest in purchasing new IRBs, even from their best corporate customers, was limited.
The Tax Equity and Fiscal Responsibility Act passed last summer by Congress cleared the air on the first question. While placing some tough new restrictions on the use of IRBs for financing such businesses as restaurants, auto dealerships, and recreational facilities, Congress authorized the continued use of IRBs through 1986 for such purposes as construction or expansion of plants and warehouses. The question of the marketability of small-issue IRBs to national investors has been addressed in recent months by two creative mechanisms that, in effect, make the bonds of assorted small companies "homogeneous" to bigtime investors: credit insurance for nonrated companies and an alternative scheme relying on bank letters of credit.
IDBI, owned by Dyson-Kissner-Moran Corp., a large private holding company, isn't the first company to insure IRBs. Among the others offering coverage for tax-exempt bonds are American Municipal Bond Assurance Corp. and Municipal Bond Insurance Association, both of which usually arrange insurance on bonds that finance larger projects of companies or municipalities that already sport investment-grade ratings. In contrast, IDBI, founded in 1981, is aiming its product at smaller and newer companies seeking to secure 20-year financing for projects costing up to $2-5 million but lacking any investment rating. During its first year, IDBI insured about $15 million worth of IRBs, and it is now licensed to operate in more than 30 states.
The idea for the new insurance designed for small-issue IRBs came from Michael Curley, a former deputy commerce commissioner of New York State and former president of the state's Job Development Authority, which issues IRBs backed by the state's own credit. As interest rates soared and the volume of tax-exempt financing mushroomed during the late 1970s, Curley -- now president of IDBI -- saw that commercial banks across the country were drowning in tax-exempt investments just as the need for national investors was rising. "Every place I went, I would hear how difficult it was to place IRBs," he recalls. But it wasn't until he had completed a two-year analysis of some $400 million worth of small issues that Curley was satisfied that the new IRB insurance product could be feasible.
While IDBI is the exclusive agent for marketing the coverage, the insurance itself is issued through Firemen's Insurance Co. of Newark, N.J., the largest of the Continental Insurance Cos. subsidiaries. Before agreeing to provide coverage for an IRB, IDBI's staff of underwriters does its own detailed analysis of the issuing company's finances and the project's cash flow and conducts interviews with management. Each month, the underwriters present their recommendations to a panel of 10 outsiders -- bankers, attorneys, and appraisers -- each of whom has an equal say in the decisions, with the exception of a representative from Continental Insurance, who has veto power over any proposal. Once approval is granted, IDBI gives a company a letter of commitment good for 180 days.
The standard premium of 7.5% of the IRB's face value -- $75,000 per $1 million, up to a maximum of $2.5 million -- is a one-time charge payable when the bond is issued. It insures against default on principal and interest for the life of the security. Curley says most banks don't want to get saddled with 20-year, tax-exempt paper. In fact, he says, "most of our referrals have come from banks." IDBI permits banks to maintain their relationships with companies by acting as the bond trustee.
Curley concedes that IDBI's insurance is priced high. When he quotes the premium cost to some prospective clients, he says, "I've seen them stand there and gulp." On a $1 million, 20-year bond, for instance, the insurance premium would increase the effective borrowing cost from 10% to 11.08%. But Curley argues that the steep charge is offset by the access borrowers gain to 20-year financing at a fixed rate, which can make a substantial difference to companies concerned about cash flow. As with other types of financing, the companies must bear such added costs as those for printing, bond counsel, and trustee services.
An alternative method of making small-company IRBs more marketable relies on pools of unrelated small issues backed by bank letters of credit. The pooling approach, which had been challenged by the Internal Revenue Service in 1981, was sanctioned by Congress in last summer's tax act. The first letter of credit -- backed pool, to be underwritten by Bear, Stearns & Co., a New York City investment bank, was scheduled to make its market debut last November with a $25 million package of small issues assembled by the Massachusetts Industrial Finance Agency (MIFA). The fixed-rate bonds for real estate will be 10-year bonds but will be amortized over 15 years. Marvin Markus, a Bear Stearns vice-president, says his firm has been retained by statewide issuers in other states -- including Michigan, Kentucky, Delaware, Illinois, Ohio, Oklahoma, and Oregon -- to initiate similar pool offerings.
Instead of duplicating the financial and other credit analyses of a company's own bank, as IDBI must do, Markus says, the pooled marketing program will depend on the work of the banks. In fact, banks will be required to extend letters of credit to customers. Since national investors aren't apt to know much about nonrated smaller banks, the individual letters of credit for the MIFA package will be augmented by a second letter issued by Bankers Trust Co. of New York, one of the nation's 10 largest banks, which is expected to qualify the entire pool for a Moody's Aaa rating. "The bondholder is looking to the master credit," Markus explains. "If a company defaults, the master credit pays."
While each letter of credit will add as much as one percentage point to the taxexempt rate, Markus believes the program will find acceptance among borrowers. "If you're talking about making small companies into Aaa credits," he says, "you've got to pay for that." Moreover, he has no doubt that the new IRB pools will appeal to large institutional investors, and he says that Bear Stearns is prepared to help create a secondary market for the bonds.
A liquid secondary market could bring cost benefits to future issuers. As more of such pools and insured IRBs are sold to national investors, some of the expenses associated with bond issuance should decline, says Peter McCausland, a Valley Forge attorney who represented Northern TechGas with its IRB financings last summer. To some extent, Northern TechGas helped break the ice in the market. But in the future, McCausland says, "These deals are going to get a lot easier to close."