Spirit Airlines ‘Triple Dip’ Analysis

Situation Overview: Spirit Airlines’ recently blocked merger with JetBlue, together with ongoing cash burn has set the ultra low-cost carrier careening toward a liquidity shortfall ahead of more than $1.1bn of debt maturities next year. With the prospect of an earnings turnaround so far proving elusive, creditors’ path to recovery may require some creative game theory.

For holders of the company’s 8% secured notes, several avenues to recovery are up for consideration. The bond originally issued in September 2020 is secured by a first lien on the company’s loyalty program and brand IP assets, though in a bankruptcy scenario the collateral may turn out to have little value given Spirit’s damaged brand and questionable future as a standalone entity.

To that point, a group of bondholders organized with Akin Gump and Evercore has raised a so-called “triple dip” argument for recovery contending that, in addition to the intangible assets backing the notes, bondholders are entitled to three other sources of value, according to a Bloomberg report.

The group contends a trio of claims permitted under the 8% notes indenture amounts to $2.85bn, sources tell LFI. But a close reading of the bond documents suggests those claims could ultimately prove to be unsecured, joining the GUCs pool alongside the $500mn convertible notes and trade claims.

Other creditors more skeptical of recovery value in a restructuring are reportedly eyeing a potential liquidation, which could unlock value in the company’s high-quality aircraft fleet. Management said on February’s fourth-quarter earnings call that the company has $500mn of unencumbered value in its aircraft along with $350mn of other hard assets—including $250mn-$300mn in a newly built Florida headquarters—$425mn of pre-delivery aircraft deposits, and around $1bn of cash and equivalents.

The 8% secured notes fell nearly 30 points after the JetBlue merger was blocked, touching lows of 48 cents on the dollar on January 18. The bonds have since regained nearly all their losses, quoted around 74 this week for a 30% yield. Meanwhile, the 1% unsecured converts, which do not stand to benefit from the triple dip argument, have seen only modest improvement over the last two months, up 12 points from their lows, but still lingering in the mid-40s for a 41% yield.

Spirit has hired Davis Polk and Perella Weinberg for help addressing its 2025 bond maturities, though it has not yet engaged in formal restructuring talks, according to Bloomberg. Meanwhile a group of convertible noteholders has organized with King & Spalding and Ducera to sort out its own recovery strategy.

Loyalty bonds: Financing structure 

The loyalty bonds were issued in September 2020 to provide Spirit a much-needed source of liquidity as the pandemic brought the airline industry to a halt. The original $850mn capital raise was collateralized by the loyalty program and brand IP assets transferred to a bankruptcy-remote SPV at a Cayman Islands subsidiary, following a pandemic-era financing trend kicked off by United Airlines that summer. A 40% chunk of the notes ($340mn) was later redeemed in connection with common shares placed with the $500mn convertible notes issued in April 2021. A $600mn add-on was issued in November 2022, splitting the 8% notes into Series A and Series B tranches totaling $1.11bn with otherwise identical terms.

At a time of rock-bottom interest rates, the 8% coupon was sufficient to entice creditors to lend against intangible assets of dubious value in a bankruptcy scenario. The notes were backed by a royalty cash flow arrangement with the Spirit parent providing for a quarterly license fee equal to the greater of (a) $11.25mn and (b) 2% of Spirit’s total revenues in the preceding four quarters, divided by four. For the full-year 2023, that licensing fee equated to $109mn, according to LFI calculations.

The OM for the 8% notes describes the loyalty program and brand IP assets transferred to the Cayman subsidiaries to back the bond issuance:

Following the Contribution Transactions and the grant of the licenses under the IP Licenses, Spirit’s Brand IP (as defined herein), including all trademarks, service marks, brand names, designs, and logos that include the word “Spirit” or any successor brand, the “spirit.com” domain name and similar domain names or any successor domain names, as well as Loyalty Program IP (as defined herein), which includes the intellectual property required or necessary to run the Free Spirit Program or $9 Fare Club, each subject to certain exceptions, will be owned by the Issuers and licensed to Spirit. 

The financing was structured by Barclays with a complex cash flow scheme that included an intercompany loan and a parent guarantee. Upon issuance of the notes, the SPV issuer on-lent the net proceeds of the offering to Spirit parent via an intercompany loan, which was to be used for general corporate purposes. With an interest rate set at 0.75% PIK, the intercompany loan provided Spirit parent access to the cash proceeds of the bond issuance without any immediate cash cost, aside from future licensing fees.

The parent guarantee provides additional credit support to the loyalty bonds should the loyalty program and brand IP collateral fall short of covering the Cayman issuer’s debt obligations. The OM for the bonds warns, however, that the notes and note guarantees are structurally subordinated to all existing and future obligations of Spirit’s non-guarantor subsidiaries. As such, loyalty bondholders’ ability to participate in the assets of non-guarantor subsidiaries upon any liquidation or reorganization of the parent are subject to the prior claims of each subsidiary’s creditors, including trade creditors.

The diagram below from the OM for the loyalty bonds circulated in September 2020 outlines the financing structure:

Loyalty bonds: Collateral value

At the time of issuance, aviation appraisal firm Morten Beyer & Agnew provided a desktop valuation of the collateral backing the loyalty bonds. It estimated the value of Spirit’s loyalty program, comprising co-branded credit cards and the Spirit Savers Club, at $1.871bn, based on a DCF calculation using management’s pro forma financials. At the same time, the firm estimated the value of Spirit’s brand IP via the relief from royalty method, calculating the hypothetical royalty payments that would be saved by owning versus licensing the brand IP assets at $1.059bn. Together, that appraised the value of the collateral at $2.93bn, equating to a 29% LTV for the original $850mn bond issuance.

Morten Beyer & Agnew most recently updated its appraisal in September 2023, using the same income-based approach to peg the value of the loyalty program at $3.152bn and the brand IP assets at $1.713bn, for a combined value of $4.865bn. Despite the operating company’s struggles over the intervening three years, that notched the value of the collateral up by 66%, reducing the bonds’ LTV to 23% despite an additional $260mn of principal outstanding. Given that valuation is greater than the enterprise value of the company, the market appears to be skeptical of the appraisal.

Risk factors included in the OM for the loyalty bonds warn that in the event of a Spirit bankruptcy, the parent may be unable to perform its obligations under the brand license agreement and the notes guarantee. Still, a Spirit bankruptcy would not constitute an immediate event of default under the loyalty bond indenture, so a bankruptcy in itself would not allow bondholders to accelerate maturity or foreclose on collateral. The OM explains the conditions required for the license agreement to terminate, and therefore for bondholders to foreclose on collateral:

Furthermore, the Required Debtholders will not be able to instruct the Collateral Agent to terminate the Brand IP Licenses unless and until (i) certain case milestones are not met or satisfied during a bankruptcy case of Spirit, (ii) an event which allow for the suspension of the Brand IP Licenses has been continuing for more than one hundred and eighty days, which clause (ii) shall not apply in an event of bankruptcy with respect to Spirit or (iii) the occurrence of certain other termination events.” 

Loyalty bonds: Indenture language

The “triple dip” recovery argument turns on language included in the loyalty bonds indenture. The three sources of value the Akin Gump group claims to have access to—in addition to loyalty program and brand IP collateral—are as follows: 1) the $1.1bn intercompany loan to the Spirit parent, 2) the parent guarantee provided to the Cayman subsidiaries for the full $1.1bn principal amount and 3) damages stemming from termination of the brand IP license agreement amounting to around $600mn at present value. Taken together, the group contends these claims sum to $2.85bn, though how these claims are monetized in a potential bankruptcy is not obvious.

Intercompany loan: The loyalty bond indenture describes an intercompany loan from co-issuers Spirit IP Cayman Ltd. and Spirit Loyalty Cayman Ltd. to the Spirit parent with on-lent proceeds of the bond issuance, though a credit agreement describing the loan has not been publicly filed. In an apparently favorable deal to the Spirit parent, the interest rate on the intercompany loan was set at 0.75% PIK, providing Spirit access to the cash proceeds of the bond issuance without any immediate cash cost aside from future brand IP licensing fees. The OM for the 8% notes describes the funding of the intercompany loan as follows:

After funding the Notes Reserve Account for the Notes, the Issuers will lend the remaining net proceeds from the Notes offered hereby through the Intercompany Loan to Parent as borrower. The interest rate on the Intercompany Loan will be 0.75% per annum and interest will be payable in kind quarterly… The Intercompany Loan is (i) subordinate and junior in right of payment to (and not subject to setoff, netting or recoupment prior to) the prior payment in full of the Notes and (ii) not subordinate or junior in right of payment to, and ranks pari passu with, any other indebtedness or payment obligations of Parent. 

The intercompany loan appears to function as an effective dividend to the Spirit parent rather than a market-rate loan between arms-length parties. Lacking a public credit agreement, it’s impossible to determine whether the intercompany loan is secured by assets at the parent, though intercompany loans entered into in similar loyalty financings by other airlines were unsecured (United Airlines, American Airlines). If the intercompany loan is effectively unsecured, recovery of the bondholders’ purported $1.1bn claim would likely require excess value to flow to the parent, ranking equally with other claims in the general unsecured claims pool.

Parent guarantee: The loyalty bonds were issued with a first-priority lien on 100% of the equity interests of the Cayman entities, guaranteed by Spirit Airlines Inc. and the Cayman Guarantors. The parent guarantee functions equivalently to other guarantees provided by the Spirit parent to its other subsidiaries, providing bondholders a claim that is primarily unsecured, and as such is limited to excess value flowing to the parent after its other secured creditors and structurally senior subsidiary creditors recover. The OM for the 8% notes describes the guarantee relationship with the Spirit parent:

The Notes will be fully and unconditionally guaranteed on a senior secured basis, jointly and severally, by (i) Spirit Finance Cayman 1 Ltd., an exempted company incorporated with limited liability under the laws of the Cayman Islands and a direct wholly owned subsidiary of Spirit (“HoldCo 1”), (ii) Spirit Finance Cayman 2 Ltd., an exempted company incorporated with limited liability under the laws of the Cayman Islands, direct subsidiary of HoldCo 1 and indirect wholly owned subsidiary of Spirit (“HoldCo 2” and, together with HoldCo 1, the “Cayman Guarantors”), and (iii) Spirit (together with the Cayman Guarantors, the “Guarantors”). 

In a bankruptcy scenario, the benefits of this guarantee are unclear. Loyalty bondholders would be dependent on excess value flowing to the parent to provide any recovery on the basis of the parent guarantee, though the company’s assets would presumably be depleted at that point. The parent guarantee also does not provide loyalty bondholders any seniority relative to other unsecured debt.

Termination damages: Finally, the loyalty bond indenture includes a clause specifying damages payable to bondholders if the brand IP licensing agreement is terminated. The conditions for termination require either a Case Milestones Termination Event, License Suspension Event for more than 180 days, or HoldCo 2’s right to terminate the agreement as defined in the indenture. The clause outlines the payments owed at various termination dates, equating to the present value of all future brand IP license fees, assumed to be $45mn per year. The damages payment at the end of year four (September 2024) is stated at a present value of $599mn.

The OM for the 8% notes outlines the conditions required for a termination of the brand IP license agreement as follows:

Upon the occurrence of any Brand IP License Termination Event, (a)(i) described in clause (a) of the definition thereof, the applicable Brand IP License shall immediately and automatically terminate (without any notice to Parent or any other act by the Brand Issuer, HoldCo 2, the Trustee or the Collateral Agent) unless the Required Debtholders have otherwise agreed, as notified in writing to the Guarantors, the Trustee and the Collateral Agent or (ii) described in clause (b) or (c) of the definition thereof, may be terminated by the applicable licensor or the Collateral Agent (acting at the direction of the Required Debtholders) and (b) in the case of the Parent Brand Sublicense, upon such termination, there shall automatically (without any notice to Parent or any other act by the Brand Issuer, HoldCo 2, the Trustee or the Collateral Agent) become due and payable as liquidated damages for loss of bargain and not as a penalty, an amount equal (x) to the present value (the “PV”) of all future payments of the Brand License Fee assuming a fixed annual license fee of $45 million from the date of termination through and including the date that is the 30th anniversary of the date of the Parent Brand Sublicense, discounted to the termination date at a rate of 10% per annum minus (y) the recovery value of the Brand IP (the “Brand License Termination Payment”). 

In the case of a licensing agreement termination resulting from bankruptcy of the Spirit parent, the source of cash available to pay the damages is unclear. The damages clause would presumably provide loyalty bondholders with a sizable claim in bankruptcy, but lacking any apparent security interest, the claim is likely to be effectively unsecured. The probable effect of the damages claim would be to further increase the size of the bondholders’ position in the general unsecured claims pool.