The future capital structure of Alitalia, or why the Air France deal really was inconvenient

The newspapers are full of embarrassing wiretaps, threatened decree laws, and the open warfare underway between the Prime Minister and Italy’s magistrates. I can see some elements of right on both sides of this controversy, but that should matter little to you or anyone else. Politics is not my area of specialization; finance is. So among the early acts of the new Berlusconi government, the nearly completed acquisition of Alitalia by Air France is front and center for examination. 

Talking with friends over dinner last night, we marveled at how extraordinarily wasteful that particular intervention was for Alitalia, for the Italian taxpayer, for Alitalia’s current investors and employees. Now, without commercial partners, adequate funding, and with oil at $147 per barrel, Alitalia is a coffin trundling down the ramp towards the crematorium flames. Or as they used to say on execution night, in Huntsville prison in Texas, “Dead man walking…. Dead man walking.”

Of course, all those with banking experience in Italy know that dying companies rarely actually die. From the bad old days of IRI and the Ministero delle Partecepazione Statale, to the bad new days of Berlusconi Due, failing companies in Italy – provided they are big enough – remain alive as zombies, sucking away at the public treasury. So let me take a guess about how the epilogue for Alitalia will read in a few years.

Commercial partners will be found. Perhaps some combination of Air One and a banking consortium, given that the banks are already in difficult straits and must somehow work their way out, by first bailing themselves in. A restructuring plan will be developed, be publicized and much praised. A large (but not large enough) part of Alitalia’s labor force will be let go, into some sort of softened (and publicly funded) pension arrangement. The company’s few remaining collateral assets, like landing slots, will be written up to “market value” (and never mind that this value is very much lower now in a world with a significantly higher, sustained oil price). Excess aircraft will be parked in the desert. Low volume routes will be cancelled. And the banks will lend again, this time in the form of super senior loans with very protective terms and pricing, and these loans will dilute the existing bondholders – not to mention anyone foolish enough to hold Alitalia stock right now (if you can get a price for it, you really should sell – even now).

And the company will be re-capitalized with a new issue of stock for the new commercial partners (presumably in control of well over  50% of the voting rights), with a substantial convertible bond offered to Alitalia’s so-called “stake-holders” – the remaining employees, current shareholders, perhaps even a key supplier or two. Thus, a “Swiss sandwich” will be created. As the noteworthy Voltaire once quipped, “if a Swiss banker jumps out of a high window, be sure to jump after him. It will prove to be convenient.”

A Swiss sandwich describes a re-capitalization where new debt and stock are created with value and legal preferences superior to existing debt and stock, so that in the seniority of the capital structure the new debt is most protected, followed by the old bonds, followed by the newly created convertible, then the senior stock, then the old stock. The parties proposing this arrangement always end up in a superior position to all other parties to the transaction, and the recapitalization is, in effect, a last roll of the dice.

If all goes well, all benefit. If not, those holding the senior-most debt will lose the least, and perhaps not lose at all. They get their new shares (and company control) essentially for free, and pay in the debt capital at face value. Everyone else is “crammed down” relative to the position they enjoyed prior to the recapitalization.

The best part in all this (for the new lenders) is the convertible bond, customarily offered to stake-holders in exchange for something real. Lower compensation. Flexible workshifts. Reduced buyouts. Perhaps all of that and more. In any case, something of real economic value.

A convertible bond, for those who may not be familiar with the instrument, is both debt and equity. It pays a coupon (usually a low coupon compared to what else may be available in the market) but after a certain number of years may be converted into common shares at a previously set price, so the investor has the protection of a regular interest payment and the promise of “upside” if the shares rise in value.

Ragazzi, let’s speak clearly. With oil hovering around $140 per barrel, or more – there is no upside to the airline business. Not now, not five years from now, maybe in a decade – after many changes, after many business failures, after a complete overhaul of the industry’s pricing structure and regulatory context. Maybe then. Not now, and not soon. It is very important that this not become common wisdom before the recapitalization is finished. First, no one would accept that convertible bond. Second, no one will buy into an eventual future placement of the new shares on the market when and if the new backers think they can get away with it.

And so Alitalia will continue to fly. Italians will continue to benefit from a compagnia di bandiera that offers appalling service, atrocious on time performance, and continues to periodically benefit from direct and indirect infusions of public funds taken directly from the taxpayer. EU rules notwithstanding. In these brave opening days of a new government, the first rule of high finance in Italy remains intact: paga Pantalone.