NEW YORK (The Deal) -- Near the end of activist investor Nelson Peltz's high-profile proxy battle at DuPont (DD), Standard & Poor's issued a "negative rating outlook" for the chemical giant, largely because of its dispute with the well-known insurgent.
Peltz ultimately failed in his efforts to get himself or three other dissident nominees named to the board of DuPont, but that didn't change the outlook for the debt, noted Paul Kurias, an analyst at S&P, who pointed out that the activist plans to "wait and watch" before deciding what to do with Trian Fund Management's $1.7 billion investment in DuPont.
A key reason for the negative outlook: prospects that the company could decide to split the business into two units after Peltz urged it to break up. A split of the business, Kurias said, could "erode" DuPont's strengths by weakening its "business diversity and operating scale," all of which will lower its credit quality. "We are still focused on whether the business is going to be split or not by an activist or management," he said.
Over at Darden Restaurants (DRI), where activist Starboard Value's CEO Jeff Smith was successful at replacing the entire board, the company was actually hit with a downgrade. Shortly after Starboard won the contest, Moody's Investors Service downgraded Darden's debt to Ba1 from Baa3 -- meaning it went from investment to speculative grade -- after it concluded that executing a "sustained and profitable" turnaround at Olive Garden is "not likely" in the "intermediate term" due to "unprecedented changes" in leadership.
While the negative outlook doesn't pose much of a problem for DuPont, which maintains its "A" rating, Darden's downgrade could mean trouble for Smith's push to have the company separate its real estate business through a merger or publicly traded REIT spinoff. That effort, at the very least, is on hold. The insurgent's other goal -- a spinoff of Darden's specialty restaurants group and its higher-end restaurant chains like The Capital Grille and Yard House == also is unlikely to happen anytime soon, and at least, not until its credit rating improves.
These two separate -- and very different -- companies and campaigns underscore the downside of activism for debt investors. Equity holders are often thrilled to see an activist appear. Darden, for instance, now trades in the mid-$60s, up from the low $50s where it was trading before Starboard showed up. For bondholders, though, the appearance of a Peltz or Smith can cause agita.
The point was driven home by an April report from Moody's with the catchy title, "Activist shareholders gain momentum in 2015, mainly negative for credit investors." Its main author, Chris Plath, argues in the report that activism is "rarely" good news for credit investors.
For one thing, activist wish lists often include things like share buybacks or financial engineering strategies, such as REIT spinoffs, sale-lease backs or splitting up the company itself. Credit raters often view such moves as too risky.
In response to Peltz's presence, DuPont authorized a $5 billion share buyback -- a tactic often used to appease institutional investors when a company is concerned about a proxy fight. That led S&P to suggest that the authorized program and any future "shareholder rewards" could "strain leverage or liquidity or both."
Columbia Law School professor John Coffee noted that activists believe that corporate boards exist to represent shareholders and no one else. He said that activists, particularly those seeking to break up companies, will urge actions that reduce debt ratings and result in cuts to research and development spending. In addition, other corporate boards, hoping to avoid becoming the target of activists the first place, are placing a greater emphasis on buybacks and dividends.
"Creditors will say we are in a world where boards are not on our side and they [bondholders] will demand a higher return because they face more risk," Coffee said. "If you can make money for shareholders but reduce the security for bondholders in the long term that will result in lower debt ratings."
In addition, while an activist may like charts showing how well the company's stock will do after a spinoff or breakup, credit analysts may take an entirely different view of what will happen if the company breaks apart.
"Analysts are perfectly entitled to take the view that the joined-up parts of the company create synergies that help maintain the credit rating and that you would want to sit on a company set up as a metaphorical three legged stool rather than a shooting stick," S&P analyst Laurence Hazell said.
To be fair, the news isn't all bad for credit holders when an activist shows up. As Hazell added, "Let's not have an automatic default setting that activism is credit negative."
He noted that activists have come a long way from their "greenmail" days 20 or 30 years ago and that lately insurgent managers often produce deep research on companies and develop ideas that are "well worth looking at" by everyone including rating firms.
Consider a credit investor in a company that's in a turnaround situation, with speculative rated debt. Such a debt holder may be happy if the activist drives a sale of the business to one that has a much better rating. In general, the acquirer will assume the debt of the acquired company, which may result in a lower rating for the buyer. Moody's in December placed Pantry (PTRY) -- which had been the target of activist investors -- on review for an upgrade after it agreed to be acquired by higher-rated Alimentation Couche-Tard (ATD.A:Toronto) (Baa2 stable). Alternatively, creditors may suffer if the sale is to a lower rated buyer.
Some activist campaigns also result in better-run companies, and, therefore, better debt ratings. At Canadian Pacific Railway (CP), for instance, S&P upgraded the company to a BBB+ in November. That followed Bill Ackman's Pershing Square Capital Management taking over the railway giant's board in 2012 and installing a new management team. S&P noted in its November report that after "aggressive headcount reductions, several productivity and efficiency measures and healthy revenue growth" Canadian Pacific met its operating ratio goals. At the same time, the railroad's stock shot up from about $73 a share in May 2012- when the board takeover took place-to about $173 a share by May 2015.
"That appears to have worked out well from the company's point of view," Hazell said.
And for some companies, such as DuPont's and McDonald's (MCD), investment grade ratings are almost assured. McDonald's, which has been under pressure from activist Glenview Capital Management LLC, last month accelerated its plan to return between $8 billion and $9 billion to shareholders in 2015 through dividends and stock buybacks. On May 15, Moody's downgraded its senior unsecured noted to A3 from A2.
But Lynne Collier, analyst at Sterne Agee, said she isn't concerned at all about Moody's move to slightly downgrade McDonald's debt rating in response to the restaurant chain's major turnaround strategy, which also involved refranchising 3500 company-owned locations.
"The stock hasn't been performing and it has been trading in a narrow range between $90 and $100 and this move is a modest positive," she said. "I think they are doing the right thing from a financial engineering perspective. I'm more concerned about the difficulty in turning around the operating performance."
Still, General Motors (GM) settled with an activist group including Harry J. Wilson, a former U.S. Treasury official who served on President Barack Obama's auto industry task force, by agreeing to a $5 billion share buyback program. Moody's described the move as a "negative" credit development that will "delay any potential consideration for an upgrade of its Baa3 credit facility rating level." Some critics argue that the buybacks are overly short term and will take money away from ongoing projects, such as the auto giant's capital-intensive process of rebuilding its auto lending unit.