The Long and Short
Vistra P-Caps top senior secured debt
Dan Bruzzo, CFA and Meredith Contente | June 9, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Vistra Corp (VST: Baa3/BBB-/BBB-) tapped the market recently with a novel 5-year pre-capitalized security (P-Cap), a structure more common in the insurance sector. Under the terms of the P-Cap, VST has set up the Palomino Funding Trust, which will use the proceeds to purchase a portfolio of Treasury debt. VST can use the Treasury debt as collateral in commodities transactions and, in return, pays a fee that gets passed along to investors as a spread over the Treasury debt. Pricing on the deal suggests a hefty concession of nearly 67 bp to equally rated senior secured bonds and looks like a good way to pick up incremental yield.
The deal provides an attractive way for buy-and-hold investors to pick up incremental yield to the senior secured bonds (Exhibit 1). We see value in the P-Caps down to a concession of roughly 35 bp, which is roughly the average P-Cap concession in the insurance sector (Exhibits 2 & 3). Even at that concession range, the P-Caps will yield more than VST’s unsecured debt that is rated Ba2/BB/BB. The structure will likely be less liquid than the senior secured bonds, but the incremental yield helps to compensate for the lack of liquidity.
Exhibit 1. VST Curves (Senior Secured and Unsecured Bonds)
P-Cap Structure Utilized in the Insurance Sector
Exhibit 2. Insurance P-Caps vs Senior Unsecured Curves
Exhibit 3. Insurance P-Caps Spread Concession
Agencies all Agree on VST’s P-Cap Ratings
All three ratings agencies assigned ratings to the P-Caps equal to those of the senior secured bonds. The agencies believe that the credit quality of the P-Caps are on par and rank pari passu with the senior secured notes (that contain fall-away provisions). The strong ratings linkage is derived from how the trust is structured to handle insufficient funds. Should the trust not have adequate funds to pay interest and principal on the P-Caps, VST is contractually required to fund the obligation through a delivery of senior secured notes, or via a substitute payment itself. It is understood that VST’s obligation to make the payment is absolute, irrevocable and unconditional. Additionally, the payment obligation is secured by a first-priority security interest of the same collateral used to secure the senior secured notes, hence the equalized ratings.
The agencies also noted that the P-Cap structure helps to support liquidity for the credit. The issuance is expected to release some of the cash collateral postings, which stood at $1.9 million at the end of fiscal first quarter 2023. VST’s collateral needs are largely tied to commodity related requirements based on natural gas prices as well as power purchases/sales. VST will be able to use the US Treasuries purchased by the trust as a pledge to meet collateral requirements of its counterparties.
Energy Harbor Acquisition a Positive for Power Generation Transformation
All agencies maintain a stable outlook on the company’s ratings post its acquisition announcement of Energy Harbor Corp., which is expected to close by the end of 2023. Under the terms of the deal, VST will pay $3 billion to acquire the energy provider and combine it with VST’s newly formed subsidiary, Vistra Vision. The new unit will also assume $430 million of debt from Energy Harbor, with Energy Harbor shareholders owning a 15% stake in Vistra Vision. The acquisition is another important step in VST’s power generation transformation as it will expand VST’s nuclear power generation by adding roughly 4,000 megawatts of nuclear capacity to its zero-carbon operations. Additionally, it will expand the company’s retail customer base by approximately one million.
VST will fund the $3 billion cash consideration largely with debt financing, which is expected to increase leverage to the 4.2x-4.4x range at closing. The integration of the assets is expected to run smoothly and enhance its already strong operational performance. That said, leverage is anticipated to decline to the 3.6x-3.8x area in 2024. VST management is still targeting net leverage of below 3.0x and has explicitly stated that it will utilize its net cash for opportunistic debt reduction. VST repaid $500 million of short-term debt in fiscal first quarter 2023, despite that being seasonally the lowest quarter for free cash flow generation. Management believes it can achieve its net leverage target in 2024-2025.
Primer: Pre-capitalized securities (P-CAPs) offer attractive spreads over comparable senior notes
Pre-capitalized securities or P-CAPs are a unique trust structure that until now had mostly been utilized by insurance companies seeking to issue debt, but also wanting to keep leverage off the balance sheet until or if the funds are eventually needed. The bonds trade in the secondary market at a sizable discount to comparable senior unsecured debt issued by the same companies. We believe investors are well compensated for the moderate give-up in liquidity and structural implications associated with these securities.
The motivational concept behind a P-CAP is fairly simple. The issuer creates a trust that accesses the public debt market, but that debt is held off balance sheet of the insurance company and does not contribute to financial leverage. The proceeds of the securities issued by the trust are used to purchase Treasuries (principal or interest strips), from which the trust will pay a coupon plus a locked in spread rate that is paid/provided by the underlying company. In effect, it is a means for an insurance issuer to essentially lock in or create an option on interest rates at a time when they view rates as attractive but might not necessarily need to issue debt. The company has a put option to issue senior unsecured debt into the trust at any time and take ownership of the treasury securities that are held (typically at increments of $50 or $100 million depending on the terms of the deal). Only at that point does the debt count toward financial leverage and the issuer have access to the funds.
All outstanding P-CAPs are rated in-line with the senior debt of the issuer, as the rating agencies view the credit quality as being closely linked to that of underlying insurance company. The notes issued into the trust upon exercise would be pari passu with all senior debt obligations of the underlying company. An issuer would choose to execute voluntarily in the event that it could no longer access the public debt markets or simply views current rates as unattractive to issue new debt. Debt issuance to the trust can also occur as a result of a mandatory exercise event, which we describe below. So far, no company that has issued P-CAPs has ever exercised either voluntarily or through automatic/mandatory action.
An automatic exercise event occurs if either a bankruptcy event occurs at the underlying insurance company, or if the company fails to make scheduled payments to the trust. A mandatory exercise event would occur if consolidated net worth of the company falls below a certain threshold, or if the company defaults on other payments or violates debt covenants. In either case, the senior debt then issued to the trust puts holders of the P-CAPs in a pari passu position with other senior debtholders of the issuer.