Williams $900M Buffett Loan: Case Analysis of Debt & Covenants

Background: Why Williams Sought Emergency Financing

Williams is a company based in Tulsa whose business operations are energy-related, including exploration and production, energy trading, pipelines, and telecommunications. At the time of this case, the company was suffering from deterioration in the energy markets as a result of the collapse of Enron, in addition to pressure on profit margins in the telecommunications sector due to oversupply and regulatory investigations into suspected financial improprieties. Williams was considering a $900 million one-year loan from Warren Buffett and Lehman Brothers for several reasons.

An oversupply in the telecommunications sector resulted in deteriorating profits and margins throughout the industry, prompting several players to exit. This led Williams to guarantee indirect credit support for $1.4 billion of WCG's debt. Correspondingly, the decline in the energy industry produced stricter credit rating requirements for investment-grade corporations. In response, toward the end of the 2001 financial year, Williams launched several initiatives to shore up its balance sheet and maintain its investment-grade credit rating. These initiatives included selling large assets to reduce outstanding debt, cutting capital expenditures, and reducing quarterly dividends paid to common shareholders. Williams also finalized the sale of $1 billion in equity-based securities. Despite these efforts, the company's credit rating was downgraded to B1.

This downgrade adversely affected Williams by hampering its ability to raise cash from the market. The downgrade was expected to severely impact the company's energy marketing and trading business — an area on which Williams heavily depended for accessible credit. Facing a loss in credit rating alongside a substantial amount of maturing debt, Williams confronted an imminent liquidity crisis. Further compounding the problem, the company's stock price had declined more than 90% in approximately twelve months, reflecting a deteriorating market belief in the company's future cash flows.

Loan Cash Flows and Internal Rate of Return

The question of what cash flows the loan will generate assumes that interest is paid in cash quarterly and the loan itself is fully repaid in one year. The internal rate of return (IRR) is the rate of interest at which the net present value of the positive and negative cash flows from a given investment equals zero. This rate is used to assess the viability and desirability of an investment or project (Atrill and McLaney, 2013).

Assuming the loan is fully repaid in one year and there is no sale of RMT, the IRR calculation is as follows:

700 / (1 + 1.18) + 900 / (1.18) > 1,026

IRR = 18%

This yield — also referred to as the yield-to-maturity, effective annual yield, or promised rate of return — represents the return the lenders are promised if Williams repays the loan in full on schedule.

Repayment Risk and Expected Rate of Return

The repayment of the loan appears to be achievable, as the expected rate of return is higher than the promised rate of return. However, repayment is not unconditionally guaranteed given Williams' financial distress at the time.

If Williams is unable to repay the loan within one year and defaults, the lenders would take possession of the capital stock and assets of RMT — which consist essentially of oil and gas properties acquired from Barrett Resources. The expected rate of return on the loan is higher than the promised rate of return, reflecting the additional default risk premium that lenders require under these circumstances.