A Deal For All Seasons
The zero coupon is to bonds as the Mexican hairless is to dogs. It looks like the traditional design, but one fixture common to the species is disturbingly missing. Why the dog evolved as bald as Telly Savalas (or vice versa) is anyone's guess, but the band's absence from periodic interest payments, or coupons (a term derived from the old days when you literally snipped payable drafts from the certificate itself), is all too explainable: this era's high cost of money. A zero, as the curious debt instrument came to be called in its heyday only a few years back, is designed so that the borrower does not have to service the debt through periodic cash payouts. Instead, the original loan is discounted from par (in bond biz, "par" equals $100) such that when the borrower pays it back at par on the due date, it yields the equivalent of the missing interest. In addition, kickers can be attached to the zero to make it even more enticing to otherwise timid lenders. These can include warrants that provide for buying more stock within a given time period, options for buying yet more -- and cheaper -- stock, stock in another corporation, interest-bearing preferred stock, and dinner at The Four Seasons.
A freewheeling zero is the kind of ingenious win/win financial showpiece that only capitalists could dream up. The borrower gets money interest-free, while for the lender the locked-up nature of the zero cements the rate of compound interest for the duration of the bond (which can be 25 years or more). When the bond is redeemed, some of the income might be reported as a long-term capital gain. With all that going for them, zero-based packages became hot brokerage-house retail items in the tight-money Carter regime, when lending rates were approaching the batting average of the Atlanta Braves. Even large and responsible public corporations seized the chance to unshackle themselves from expensive debt service, and to cast their lot with possibly better borrowing terms next century. So did marginal operations that could barely meet their Coffee-mate budgets.
The no-tickee no-money concept is neither new nor necessarily suspect. Certain federal obligations have been auctioned at original-issue discount (OID, to your accountant) for decades; you lend the federal government $900, say, and in a year the U.S. Treasury (if it's still around) will give you back $1,000, paying 11% interest. Now that the cost of capital somehow has Laffer-curved back into single digits, however, zero coupons have shed much of their service-free cachet. And a 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) provision that holders of zeros and other OIDs must pay taxes as if they had collected the interest payments has but the kibosh on the retail market as well.
That might have been sufficient to maim an ordinary capital scheme like, say, the research and development partnership. Not so the flexible zero. An inventive application of OID financing recently emerged as an early-round font of working capital for a start-up enterprise. The business -- Air Atlanta Inc. -- was incorporated in May 1981 by Georgia native Michael R. Hollis, a then-27-year-old lawyer and investment banker. In an industry noted for its swift consumption of cash as well as gas, one of deregulation's newest airlines has been issuing zeros for the lion's share of its money. Although more than $5 million was raised in common stock, as of year-end 1985, interest-free debt instruments -- in this case, convertible debentures -- accounted for roughly $19 million of Air Atlanta's total funding of $54 million, exceeded as a single source only by a capital lease on its fleet of jets.
The company's reliance on a zero coupon convertible debenture for its very sustenance is thought to be unique not only in the annals of the airline industry, but among start-ups anywhere. Nor do the contributions come from kinfolk taking fliers. Air Atlanta's lenders are such demanding investors as Aetna Life Insurance, Equitable Life Assurance Society of the United States, and General Electric Credit, which together have loaned $13.6 million via zero coupons to the still-profitless carrier.
How were traditionally conservative asset managers persuaded to take on unsecured debt, payable no sooner than five years from issue, by a fledgling carrier that had only four routes and five planes; had been forced to cancel a public offering due to lack of Wall Street sponsorship; owned few assets (and those pledged as security under other instruments); was knocking heads with Eastern and Delta out of Atlanta by promoting deluxe service (including gourmet meals, free drinks, wide seats, and shrunken margins); had yet to enlist a big-name airline to feed in passengers; and was trying to take off vertically in a sector where no airline has made a profit in its first year and in which other haulers were dropping like -- to be discreet -- flies?
Keep sweetening the deal, answers Daniel H. Kolber, a corporate attorney who worked with founder Hollis on designing the zero vehicles. Saddled with the title of vice-president of communications and industry affairs for his efforts, the diminutive executive insists that rounding up wherewithal is mostly a matter of being able to answer skittish investors' objections.
"It's the same as closing any sale," avers Kolber, who helped coax the deal around a New York statute prohibiting insurance companies from owning voting shares by an on-the-spot redefinition of the proffered stock as Class B nonvoting, amendable to Class A voting at the lender's, if not the state legislature's, discretion.
Like apricot jam in a Sacher torte, the tastiest layer of Air Atlanta's debentures is their potential transmogrification into a generous chunk of ownership. But why not peddle common stock in the first place? For one thing, it would have been though to convince venture capitalists to back a couple of buddies only a few years out of the University of Virginia School of Law, one black, the other white.
"We would love to have done common," Kolber admits, but as an alternative, borrowing appealed to their sense of fiscal adventure. "We got in the mood to put out paper," Kolber recalls with youthful insouciance. "We didn't want a demand note, though: in 60 to 90 days we'd have to come up with the cash outlay. If worse came to worst, we could always ask for deferral, but we wanted deferral built into the structure. Companies were starting to sell junk bonds and putting a lot of juice on them -- you know, commissions; but we couldn't afford a lot of commission, so how could we sweeten it? Sell it at a deep discount!
"Back then, the zero was getting a lot of press, and it seemed a perfect way to get money without paying interest. It would still be accruing the interest, but we wouldn't have any cash outlay. We would have a current liability, yet it wouldn't impact our cash flow," says Kolber. For Air Atlanta's purposes, since it lacked a revenue stream, convertibility sprouted naturally: first, get the money; worry about dilution of ownership later.
The resulting instrument could not be taken for a Stradivarius; yet the complicated tune it played coaxed coins from deep and normally tight pockets. Among the covenants: what circumstances would constitute default; restrictions on additional borrowing and stock sales; lenders' access to company financials; and provisions for Air Atlanta to be able to force conversion should, God willing, the value of the company increase beyond the per-share conversion price.
The zero-coupon debt debut -- a five-year debenture for $4 million that netted the borrower $2.5 million -- was signed with Equitable on February 23, 1984. Starting three years from that date, the note was convertible into common stock at prices ranging from $10.04 per share to $10.52. "And we sweetened it more," admits Kolber. "In this particular transaction, we gave them some options at a very low price."
Low is hardly the word: 40? a share is what investors expectantly refer to as the "quid." The attraction for Air Atlanta was that although it received only 62.5% of the note -- a discount based on compounding 12.5% annually for five years -- it would not be obliged to reserve even a dime for debt service. "Ordinarily, we would use 96% of it for working capital, and the other 4% for backing debt. Instead, they were telling us to keep the 4. We got more than we asked for!"
Since its cash requirements were projected toward the lump-sum net, rather than on the face value of the note, Air Atlanta met its working capital budgets without giving anything away -- for the time being. The lenders, bent on protecting their prodigy from capital burdens, didn't even formally require a "sinker," or sinking fund, in which cash must be amassed to guarantee the borrower's ability to pay at maturity. If by close to business on February 22, 1989, Air Atlanta has become profitable with its net worth expanding briskly, the debenture holder will convert to common, and early-stage funds will have cost little save dilution of ownership five or so years later. By then, few stockholders will be the sadder, since in converting, the erstwhile bondholders will have wiped debt off the books and turned it into paid-in capital. No rich uncle could have treated a deserving nephew more kindly.
Its unorthodox zeros aside, a student of start-up techniques tracing Air Atlanta's tireless search for capital would uncover an intriguing (yet aboveboard) maze of cross-default provisions and cross-collateralization of such fluctuating assets as accounts receivable. For example, the company's airport gates, on long-term lease from the city of Atlanta, were recently mortgaged -- a bold leveraging tactic. But not even the company's bank, the National Bank of Georgia, which itself is keeper of several convertible Air Atlanta notes, has raised an eyebrow. The bank is the only Air Atlanta creditor to insist on a minimum cash balance, yet, reports Kolber, "they view the zero as a basically conservative debt instrument."
But that's not the way other lenders are playing it. For their unsecured exposure, the funds managed by Equitable, many of which also hold well-rated, long-term, paying securities of established airlines, get to speculate on a start-up -- a capital position they would not explicitly take via raw seed capital. "To them," explains Kolber, pointing north toward the money managers who ultimately bought into the offering, "zeroes look and taste and smell like regular subordinated debentures. They're used to dealing in deep discounts; they buy each other's paper. It's only when you put the thing together and shake it up that ours is unusual. It's a ticket to play the game without looking like a venture capitalist."
In corporate finance, though, tickets don't come with rain checks against risk. A zero debenture like Air Atlanta's might literally be worth zero before it could be flagged as a loser. Even if the struggling company was on the verge of going under, a zero would be carried in the books as debt in good standing and would appear respectable enough to an insurance company regulator probing the books. There would be no missed payments, and thus no provisions for a write-down.
To avoid catastrophe if a company were seen to be in danger of going under, the creditor would do well not to accelerate the note and cause trouble, but instead to write yet another large check, and then another. With a company capitalized mostly through debt, lenders who draw working-capital purse strings too tight can kiss previous investments goodbye. Even though a bond provides a measure of leverage beyond ordinary stockholdings, an unsecured zero can easily send a portfolio manager into an unemployment line.
"Doing a zero with start-up companies is a high risk," agrees Slivy Edmunds, Equitable's pivotal zero-voter as assistant vice-president of corporate finance -- but not an unexpected one. "You use it where you're willing to take an equity risk," explains Edmunds, disclosing the true timbre of Air Atlanta's odd instrument. "You should not evaluate the investment as debt. The determination would be whether or not you would take equity in the company. And to be comfortable with an equity risk, you have to be prepared to lose all your money."
Still, do you have to be prepared to lose more than all your money? This startling possibility was brought about by 1982's TEFRA tax provision. With a zero that is convertible into common, you pay taxes on the uncollected interest and then hope for the best; with equity straight out of the starting gate, you merely hope for the best. If the best ends up in bankruptcy, it might come about that the investor who has been dutifully paying taxes can get nothing back from a worthless zero, and will be out the levies as well as the loan itself. Whether a sympathetic Internal Revenue Service review of the case would allow recovery of the taxes has yet to be tested.
Although by its nature a debt obligation with restrictive covenants places something of a cushion under the equity play, in bankruptcy court it could turn into a Whoopee Cushion. A zero convertible debenture's standing in a Chapter 7 or Chapter 11 is still untested. If it comes to that, the judge will have to rule whether an unsecured convertible zero debenture is true debt or thinly disguised equity. The bondholder, of course, would plead the case for debt, and thus rank it senior to common stock.But real-interest-bearing unsecured debt-holders would argue that the start-up company, what with its liberal conversion factors and the assortment of options and warrants that also reek of equity, ever intended to pay back the loan. Yet Equitable and other long-term zero holders will have been paying taxes on interest accrual. Thanks to the IRS, that's undeniable proof -- however layered with options, warrants, and convertibility -- that the instrument constitutes a loan. Moreover, by the same argument, a secured zero convertible would have equal license with any other secured note to go after available assets.
So far, Air Atlanta has been able to borrow nearly at will. To do so, it must secure waivers from its creditors, but, says Kolber, "that has never been a problem, because we are adding value to the company." But unforeseen snares could yet develop, not only for the investor, but for the beneficiary. What if, when in five years the note matures and it comes time either to convert or to be paid back in cash, the deal is a wash -- that is, the value of the stock is exactly equal to the face value of the note? An uneasy lender might opt to get its money back while the opportunity was there, instead of taking the common and chancing a still-clouded future. In that case, even though Air Atlanta had enough cash to meet its debt obligations, it still could be grounded.
But Equitable and other lenders are not asking for a parachute. "If we needed a secured position," Edmunds admits, "we would not consider a zero. There has to be upside potential. If we went for current return, the upside participation would normally be reduced."
Surely one wouldn't want anything so passe as current return to blemish an idyll in which management owns less than 1 million shares of common -- far less than Equitable and others control through conversion. On top of lending over $10 million in zeros -- convertible into nearly 5 million shares -- Equitable holds such other modes of convertible debt as secured demand notes, plus warrants and options to load up on yet more common. Equitable already is about a 15% owner, based on outstanding shares. If everything is exercised before convertibility expires (even if the other lenders make all their conversions) it will come close to owning half the company (on a diluted basis). This is a far larger chunk of the corporation than they would have had through early-stage equity alone.
That happy event will occur only if the new airline soars into the wild black yonder. If it continues to cruise in and out of the red, however, yet another complication could arise should Air Atlanta again attempt an initial public offering, either to raise more capital or to establish a market price for its stock. Convertible holders would want to cash out as well, but the days of capitalizing profitless companies merely by tapping the public market have passed, and no underwriter could be expected to sell stock from debt-laden balance sheets. Equitable and other lenders would have to cooperate, cleaning up the liabilities by converting to common. They would then hope to "piggyback" on the offering and dispose of at least some of their holdings. Unfortunately, Wall Street has come to frown on IPOs that seem designed to favor individual holders. The idea of an IPO is to let the public in on a good thing, the Securities and Exchange Commission agrees, not to bail an institution out of a flat investment.
In the end, the beauty of a zero convertible is in the eye of the holder: it looks like it's a performing asset, such as revolving debt, but it's really not.It reflects the tacit intent of both parties to structure debt that accrues interest, but which the borrower has no intention of redeeming. Still, even the borrower's highly explicit willingness to bathe its creditors in equity surely is not the sole reason big money came to Air Atlanta, whose management in any event is worth betting on. However, Kolber reckons, "they invested more because of it. We were able to go to the well again, where we wouldn't have gotten a penny if they could say they were maxxed out on the equity side, and you're not going to get anymore. Now we can answer, well, this isn't really equity."
If it's so magical a device, why don't more start-ups use it? There's no apparent reason, Kolber concludes. "The only argument against a zero coupon is its lack of an income stream. It's not an instrument for traditional venture capitalists. They have to have dollars coming in. Yet it's such a flexible creature -- you can keep layering and layering it, and fine-tune the covenants and the restrictions, and play with the cross-collateralization. At first it seemed like there had to be something wrong. Were we being naive? Were we missing some tax thing or accounting standard? Is it really this simple?"
The jury may still be out, but so far, so good. After the concept and its various sweeteners were scrutinized by the company's accounting firm, Peat, Marwick, Mitchell & Co., and given official blessing, "that's when the phones started ringing," Kolber says. On the other end of the line were cash-hungry start-ups, wanting to know how to do it themselves.
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