Europe high-yield investors’ letter unpicked

Author: Tom Young | Published: 5 Mar 2015
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European high-yield investors have written another letter outlining six key concerns they say need addressing within the asset class. But counsel believe that while the dialogue is necessary and welcome, not all of their concerns are warranted.

The letter, addressed to the Association for Financial Markets in Europe (Afme) raises disclosure, Rule 144A offering processes, covenants, portability, voting, ranking, security and call structures as key issues that need to be clarified.

The document, signed by 21 major buyside firms including Alliance Bernstein, Legal & General and Fidelity, continues the tradition of high-yield investors’ fondness for letters of concern aimed at underwriters, sponsors and issuers. In April 2011, a similar group of market participants wrote a similar document outlining their grievances.

IFLR spoke with the region’s leading high-yield lawyers and bankers (mostly anonymously) to assess the reasonableness of the buyside’s requests. We then put the points to Afme’s Gary Simmons, who coordinated the letter on behalf of Afme, to carry on the conversation.

Here are the buyside community’s six key concerns, analysed:

1  Disclosure

The group want open and transparent reports and accounts, in line with US high-yield practice. Their letter encourages issuers to include such information in offering memorandum or make it available on Bloomberg or the issuer’s investor relations page.

Counsel were split on this. One argued that there are certain points within intercreditor agreements that don’t impact investors, but are commercially sensitive to companies and sponsors. "They don’t necessarily want you to disclose the whole thing," said one London-based lawyer.

Another partner disagreed. "This [argument] is always raised, especially in the context of senior facilities agreements, and it’s not popular because the sponsors feel, rightly or wrongly, that there’s a proprietary secret they have managed to bake into their credit facilities. The buyside stating its importance is no bad thing."


No one, whether buyside or sellside should have the incentive to hide things


There was consensus over full disclosure on conduit deals though, where all lawyers agreed that it was necessary. In conduit deals, the only way to add bond debt to the existing bank structure is to issue the bonds at a special purpose vehicle (SPV), take the proceeds and on-loan them as a new tranche of the bank facility. So while the borrowing entity hasn’t issued bond, the SPV has. "When we do conduits, people have accepted that you give people intercreditor agreements and the senior creditor facility agreements," said one counsel.

The buyside group also called for more time to be devoted to discussion of covenant features (particularly those considered atypical) and call protection during the roadshow process.

This was met with hostility. "It won’t make the offering process smoother," said one lawyer, insisting that the process works on the basis of supply and demand and obtaining the best price for the issuer. "To do that you have to create competitive tension between people and not open it all up to the lowest common denominator. People don’t have to buy if they don’t want to," they added.

"We would end up entering a relationship with investors on roadshow, almost as a prelude to renegotiating the covenants each time. That would be a disaster and never works. It makes a nonsense of the roadshow process and investors will never accept it," he added.

Afme’s Gary Simmons clarified the buyside’s concerns though. His understanding of the point investors were making was that an unusual or non-standard feature such as very short call period or the effects of Ebitda [earnings before tax, depreciation and amortisation] synergies should be clarified and discussed during the roadshow to give people a chance to understand it.

"This would then enable more clarity and transparency," said Simmons. "Some banks don’t see this as a big problem but I believe this is the point investors were trying to make."

KEY TAKEAWAYS

  • European high-yield investors have written a letter outlining six key concerns within the asset class;
  • Here, issuers’ counsel and bankers have responded to the concerns, agreeing with many but disputing the validity of others;
  • Many accept that although investors must accept widening carve-outs and aggressive covenants in an issuer-friendly market some drafting, particularly around disguised portability, must be clearer;
  • Some opposed comments around contribution debt and the request for more time to be devoted to discussion of unique covenant features during roadshows.

2  Rule 144A offering process

Less contentious was investors’ request for participants to maintain the US 10b-5 standard, which has been a critical component to the market’s success. All lawyers agreed with that, and most expect it to be the default standard. "There is no rationale for watering down the disclosure. These are chunky deals with real potential liability," said Adam Farlow, partner at Baker & McKenzie in London.

But one banker did complain that if investors were unhappy with due diligence standards on a Reg S English law deal, they should take it up with the European Commission and lobby for a change in Prospectus Directive (PD) standards, rather than market participants. "They should speak to the EU, because we can’t change that," he said.

3  Covenants

Investors’ comments over covenants generated plenty of debate. Buyside noted that the general rise of carve-outs has increased, limiting the efficacy of restrictive covenants.

And while counsel agreed that the scope of carve-outs had certainly widened, some took particular issue with opposition to the contribution debt covenant. The feature states that if an issuer raises a certain sum of equity it can raise debt for the equal amount. That 1:1 ratio is relatively modest; the leverage model most companies apply amounts to around 30% of equity and 70% of debt. Most market participants accept that the equity cushion in a company is always a smaller percentage than the total amount of debt. "So why should investors object to a matching like-for-like equity/debt ratio? It’s not geared at all," said one lawyer.

Again, Simmons was more sanguine about the request. "I don’t think this was a major point in the letter, but some investors felt that at times, the feature does leave open the door for increased leverage and weakening of the existing debt’s position in the structure."

There was a general feeling among interviewees though, that the problem lay more in the drafting than the occasionally aggressive features themselves, which were purely a symptom of a four-year issuer’s market.

"No one, whether buyside or sellside should have the incentive to hide things," said Farlow. "It’s up to us as counsel to make that clear. But once that is clear, it is totally up to the buyside to make a call, on both pricing and whether they are comfortable with the covenants," he added. "The buyside has to continue to assume that any flexibility issuers take for themselves is going to be used. But then it needs to be priced accordingly," added a London-based banker.


It makes a nonsense of the roadshow process and investors will never accept it


4  Portability

Portability provisions have been a grievance for over a year now. Buyside oppose its evolution from being used in specific circumstances where change of control was likely, to current conditions where it is incorporated more generally. Last year it was used in 30% of deals – sometimes more than once.

Issuers’ counsel have traditionally countered the complaint by arguing that the provision is rarely utilised because control rarely changes.

But the letter has developed the argument, citing more abstruse uses of the provision. 'Portability through the use of a NET leverage ratio is particularly problematic due to the potential injection of equity or subordinated shareholder debt to manipulate leverage down for the simple purpose of taking advantage of portability,’ it stated. 'This is especially true if the restricted payments covenant does not then exclude such equity or subordinated shareholder debt injections.’

Two issuers counsel told IFLR they agreed with the sentiment here. "The provision should only be used in deals where there is a real likelihood that the issuer will get rid of the company in the non-call period. That leverage ratio complaint is exactly right. That is true and it needs to stop."

The letter also raised concerns around so-called disguised portability, which is possible through an extended definition of 'permitted holders’. Again, the complaint spoke of a wider grievance, which was not the features themselves, but the belief that at times they were being smuggled into intercreditor agreements through the definitions rather than in the executive summary.

Farlow agreed with the complaint around disguised portability. "As a general matter, people should be clear on what they are buying and you shouldn’t try to trick them in the definitions," he said. "No investor should ever feel that they have been duped – portability or otherwise."

5  Voting, ranking and security

The investor group took umbrage with voting rights, stating that where bonds are claimed to rank pari passu with other debt, it should be reflected in equal voting rights.

Simmons pointed out that historically, bank creditors had most of the power in these structures, not only because they were closer to the issuers but also because many bonds were subordinated to bank debt. By definition, bank debt had a better position in the financing structure and in some cases had to be convinced to relinquish that position.

"But this point goes to the situation where the bonds and the loans are now effectively pari. So bondholders would expect that they would be pari throughout the structure, including in a default, insolvency or restructuring scenario and with respect to voting generally."

Some disagreed though. "This complaint doesn’t make sense. We are at pari voting rights in most cases anyway," said one lawyer. Adam Farlow was more diplomatic. "Voting sounds easier than it is in practice. It’s not hard to take a view that one euro-one vote makes sense. But in the context of give and take over intercreditor and how different groups in the structure relate to each other, is easier said than done."

6  Call structures/redemption

Finally, the issue of call protection in first time issuer bonds – a feature creeping into deals last year – is particularly unappealing, according to the letter. 'This is due to the resources required to invest in a new credit weighed against an investment horizon that could be as short as 18 months,’ it stated.

Counsel agreed. "The first time issuer point is fair, and shouldn’t be included," said one.

See also

European high yield’s future battle ground

Portability: clause without a cause?

European high yield tussles over change of control