Diamond Sports’ Proposed Exchange Offer Could Significantly Reduce Company’s Liquidity; DSG Has Significant Flexibility to Transfer Assets to UnSubs, Sell Assets Without Having to Reduce Debt

Relevant Items:
Diamond Sports Covenants Tear Sheet, Debt Document Summaries
Diamond Sports Debt Documents

On May 12, Diamond Sports announced that it was commencing an exchange offer for its $1.82 billion outstanding 6.625% senior unsecured notes due 2027 for $850 million of newly issued senior secured notes due 2026 and cash, and concurrently is soliciting consents from the unsecured noteholders to “eliminate most of the restrictive covenants and certain of the events of default contained in the Senior Notes Indenture.” The total exchange consideration will range from $570 to $600 per $1,000 face amount of the senior unsecured notes depending on when holders tender their notes.

Diamond Sports’ capital structure as of March 31, assuming all outstanding unsecured notes are tendered after the early tender deadline, is illustrated below for reference.
 
The newly issued exchange notes will be secured on a pari basis with debt under the company’s existing term loan and revolving credit facility and its existing senior secured notes due 2026.

The exchange offer is set to expire on June 9, and the company announced on June 2 that 3.62% of the unsecured notes had been tendered prior to the early tender deadline.

The unsecured notes were issued in August 2019 in connection with the company’s formation to acquire a portfolio of Fox-branded regional sports networks (RSNs) and, as recently as February, had been trading above 90, according to Refinitiv. However, with the closing of the global economy due to the Covid-19 pandemic, including the suspension of all major sports, the unsecured notes traded to a low of 49.5 on April 6.

The unsecured notes were trading at 53 when the company announced the exchange offer and have since traded up to around 72.
 
The unsecured notes are subject to a make whole premium prior to Aug. 15, 2022, and a call premium prior to Aug. 15, 2024.

During the first quarter, the company redeemed an additional $200 million of preferred equity issued by Diamond Sports Holdings LLC in connection with the acquisitions (the company had previously redeemed $300 million of preferred equity) and was required to purchase a minority interest in one of its RSN for $376 million following its minority partner’s exercise of its put rights.

On the company’s first-quarter earnings call on May 6, management disclosed that it paid $2.5 million at the end of the first quarter to purchase about $5 million in principal of the unsecured notes and that it was evaluating “a lot of proposals” regarding financing alternatives to optimize the company’s capital structure.

Echoing this sentiment in the confidential offering memorandum, offer to exchange and consent solicitation statement, the company disclosed:
 
In this article, we first discuss how the company is permitted to consummate the exchange under its credit agreement and secured notes indenture and the exchange’s impact on the company’s liquidity, and then briefly discuss certain other liquidity enhancing transactions the company could be considering.

We find that, although Diamond Sports can consummate the exchange transactions, because of the increase in its pro forma first lien leverage, the credit agreement’s first lien maintenance covenant could reduce the company’s liquidity. The company also has significant flexibility to transfer assets to unrestricted subsidiaries and to sell assets without being required to use the proceeds to reduce debt or reinvest in the business.
   
In order to consummate the exchange transaction, Diamond Sports must be permitted to (i) incur $850 million of first lien debt and (ii) prepay at least $1.82 billion of the unsecured notes.

Because prepayment covenants under the credit agreement and the secured notes only restrict Diamond Sports from prepaying payment of subordinated debt, the company is not restricted from prepaying or purchasing the unsecured notes.

As illustrated below, Diamond Sports is likely permitted to incur at least $2.15 billion of pari debt under the credit agreement and the secured notes; under the secured notes, the company is arguably permitted to incur an additional $6.1 billion of pari debt.
 
Taken together, under its debt documents, Diamond Sports should be permitted to consummate the exchange transactions.
 
Assuming full participation, as illustrated above, the exchange transaction would result in a $970 million reduction in outstanding debt and reduce Diamond Sports’ total net leverage to 6.44x from 7.04x, using $1.122 billion of LTM attributable EBITDA as disclosed by the company in the exchange memorandum.

However, the company’s first lien net leverage would increase to 6.44x from 5.42x, as its balance sheet cash would be reduced to $187 million from $483 million, according to the exchange memo, and outstanding first lien debt would increase to $7.4 billion from about $6.6 billion.

Diamond Sports’ credit agreement includes a 6.25x first lien leverage ratio financial maintenance covenant for the benefit of the revolving lenders that is tested whenever revolving usage exceeds 35% (about $227.5 million) on the last day of any fiscal quarter.

With $225 million drawn on the revolver as of March 31, if Diamond Sports were to draw an additional $3 million on the revolver, the maintenance covenant would be triggered. Based on the company’s financials as of March 31, once triggered, the maintenance covenant would limit the company from incurring more than $934 million of additional first lien debt.

As such, to the extent the company issued the full $850 million of first lien exchange notes, it would only be permitted to incur an additional $84 million of first lien debt, which would limit its ability to fully draw on the revolver.

However, given the company estimates the need to use $296 million of balance sheet cash to consummate the exchange, as illustrated below, its first lien leverage following the issuance of $850 million of first lien exchange notes would cause its pro forma first lien leverage to exceed the maintenance covenant’s 6.25x first lien threshold.
 
As such, to the extent the company consummates the exchange, its overall liquidity could fall to $189.5 million (including $2.5 million of revolving availability and $187 million of cash) from $908 million (including $425 million of revolving availability and $483 million of cash).

To the extent Diamond Sports’ EBITDA begins to improve, its ability to access the revolver would correspondingly increase.
 
In recent weeks, Travelport and Cirque du Soleil have transferred assets to unrestricted subsidiaries in efforts to enhance their liquidity. Party City also recently proposed a series of exchange transactions that included transferring assets to an unrestricted subsidiary to enable that unrestricted subsidiary to raise secured debt to be used as part of the transactions.

Diamond Sports has significant flexibility to transfer assets to unrestricted subsidiaries under its credit agreement, secured notes and unsecured notes.
 
In addition to at least $500 million of capacity under a general investments basket and at least $250 million under a basket for investments in unrestricted subsidiaries, Diamond Sports has access to at least $500 million of additional capacity under a builder basket, plus additional amounts based on adjusted EBITDA from closing/issuance, less 1.4x interest expense in the same time period.

Although capacity under a basket permitting at least $500 million of investments in “Similar Businesses” was likely not intended to provide the company with additional flexibility to transfer assets to unrestricted subsidiaries, given the definition illustrated in the table above, there is no explicit restriction that would restrict an unrestricted subsidiary from being deemed to be a Similar Business.

Taken together, Diamond Sports can likely transfer at least $1.725 billion of assets to unrestricted subsidiaries.

Importantly, however, because “Consolidated EBITDA” under the credit agreement and the notes includes EBITDA of Diamond Sports and its restricted subsidiaries, the EBITDA of any assets transferred to unrestricted subsidiaries will reduce Diamond Sports’ Consolidated EBITDA under the credit agreement.

While, under the notes, the company could also use a $500 million general restricted payments basket for additional transfers - the credit agreement has the same basket, but the company is unable to use it to make investments - following the $500 million of preferred equity redemptions, there is likely no capacity remaining in that basket.
 
While the credit agreement and the secured notes generally require Diamond Sports to use asset sale proceeds to ratably repay the term loans and the secured notes (Diamond Sports can use asset sale proceeds to purchase the secured notes in the open market at market prices, rather than at par) or reinvest in the business, they also provide the company with a number of mechanisms that could be used to circumvent those requirements. Because the unsecured notes permit the company to first apply asset sale proceeds to secured debt repayments, our discussion below focuses on requirements under the credit agreement and the secured notes.
   
The credit agreement’s asset sale sweep is only triggered for sales that result in cash proceeds in excess of $150 million. The secured notes’ definition of “Asset Sales” excludes sales of property for less than $500 million.
 
While the secured notes require that 75% of the consideration for all Asset Sales consists of cash and cash equivalents, the credit agreement requires that 75% of the consideration for all sales in excess of $500 million consists of cash and cash equivalents.

Because the asset sale sweeps under both the credit agreement and the secured notes only apply to cash proceeds, any noncash consideration received in connection with an asset sale will not be subject to mandatory prepayment requirements.
 
The 75% cash consideration requirement under both the credit agreement and the secured notes does not apply to the greater of $450 million and 5% of total assets ($542 million as of March 31) of noncash consideration.

Under the credit agreement, because the 75% cash consideration requirement only applies to asset sales in excess of $500 million, Diamond Sports can likely consummate more than $1 billion of assets sales without being required to receive any cash proceeds as consideration.
 
The percent of asset sale proceeds that are subject to the mandatory prepayment provisions under the credit agreement and the secured notes will step down if Diamond Sports can meet specified pro forma first lien leverage tests.
 
Diamond Sports’ credit agreement and secured notes permit the company to incur secured debt under “Permitted Receivables Financings” not to exceed the greater of $620 million and 40% of EBITDA, subject to certain conditions, including that such debt is nonrecourse to the company or any of its restricted subsidiaries and that such financings relate only to certain accounts receivable. As of March 31, the company reported $518 million of accounts receivable.

Because both the credit agreement and the secured notes explicitly carve out debt under receivables financings from the definition of “Consolidated Total Debt,” receivables facilities could not only increase the company’s liquidity but borrowings under the facilities would not increase the company’s leverage under its debt documents.