High Yield Aggressive Terms Digest: 2016 – Look Back in Anger?
High yield bonds continued to experience credit erosion driven by the extremely benign climate in credit markets and stiff competition from the syndicated loan market as to both pricing and the willingness to adopt bond-style borrower-friendly terms. This digest summarises some of the aggressive bond terms seen during 2016 which are covered in more detail in Debt Explained’s Market Update: Aggressive Terms in European High Yield 2016.
This covenant has been eroded in three ways. First, via the use of a “free and clear” basket added to the build-up basket and available ab inito without reference to accumulated profit. Secondly, through the Issuer’s discretion to reclassify Restricted Payments enabling Issuers to free up capacity in the build-up basket to make distributions but also allowing them to game the covenants to their advantage (i.e. in anticipation of a subsequent deterioration in profitability). Finally, via the increasing acceptance of a Restricted Payments carve-out
The Restricted Payments covenant allows leakage (i.e. distributions of cash or assets outside the Group) if the Group’s financial condition has improved since issuance. This is calculated on the positive balance in the build-up basket based on the group’s cumulative CNI (i.e. being 50% of accumulated profits less 100% of accumulated losses since issuance) together with various other additions involving injections of cash into the Group calculated from the quarter ending immediately prior to the issue date.
The increasing ability of Issuers to make payments outside the restricted group with asset sale proceeds has undermined the protection afforded by this covenant. There are myriad ways in which Issuers have done this, including: via a carve-out to the asset sales definition allowing restricted payments with proceeds that do not need to be applied via the covenant’s waterfall; carving out specific asset sales which proceeds will be used to make payments; allowing such payments via a Restricted Payments carve-out; and allowing asset sale proceeds to be added to the CNI build-up basket in the Restricted Payments covenant without having to go through the covenant’s waterfall provisions.
Bonds allow asset sales but generally protect investors by restricting the type of proceeds received and by requiring the Group to apply the proceeds through a payment waterfall; first, to replace the assets sold; secondly, to prepay debt pari passu with, or more senior than, the notes; and thirdly, to make an offer to repurchase the notes to the extent any excess exceeds a de minimis threshold.
Reinvestment risk is a key consideration for investors particularly in the case of fixed rate instruments. Bonds mitigate this risk via a “make-whole” provision that applies for an initial non-call period and aims to alleviate the risk of value erosion arising if the notes are redeemed below fair value. This protection is subject to certain exemptions which have experienced erosion on two fronts: first, the Equity Clawback and second, Special Optional Redemption. The former allows Issuers to redeem a percentage of the notes following an IPO during the non-call period at par plus the coupon without paying a “make-whole” providing a certain percentage of the notes remains outstanding (usually a reciprocal of the clawback). Historically the equity clawback was 35% but this has crept up over time, with the majority of deals now at 40%, and even one at 45% (Loxam Senior Secured 2021).
Special Optional Redemption gives Issuers the right to redeem a percentage of the notes (usually 10% of the original principal amount of the notes), in each 12-month period of the non-call period, at a premium (typically 103%) plus accrued interest.
The non-call period for a fixed rate bond is typically half the term of the bonds and the Issuer will usually be required to pay a make-whole to that date. Thereafter call premia kick in usually half the coupon declining ratably thereafter. The make-whole comprises the earliest call price and the net present value of all coupons that would have been paid through the first call date, which is determined by a pricing formula utilizing a yield equal to a reference security (typically government securities)
The Equity Clawback (and, to a lesser extent, Special Optional Redemption) present two risks for investors. First it deprives them from capitalising on any uplift in the value of their notes, which may be trading at a premium owing to the Group’s enhanced creditworthiness and/or a general decline in interest rates. Although Special Optional Redemption applies at a higher premium than the Equity Clawback, investors could also forfeit value if the notes are trading above the redemption premium. Secondly, although an IPO is a positive credit event and should enhance the value of the outstanding notes through deleveraging the Group, it could also impair liquidity (and thus the value) of the notes left outstanding particularly in the case of a smaller tranches of notes. Whilst liquidity risk is less of an issue for Special Optional Redemption, if exercised in tandem with the Equity Clawback, it could mean up to 50% of the notes could be redeemed during the non-call period without the benefit of a make-whole, effectively magnifying illiquidity and value loss for investors.
The key protection for investors relies on the fact that the assets disposed of are valued on an arm’s length basis. The ideal approach is to require board approval (preferably by independent directors) for disposals above a de minimis threshold with a fairness opinion from an independent bank in the case of disposals above an even higher threshold. Whilst most deals have retained some measure of these protections, Debt Explained has seen further amelioration of these protections over the past year.
An Affiliate typically includes any entity that controls, or is under common control, with the Issuer
Flexible Ratio Calculations, Complex Definitions, and Aggressive Add-backs
Various financial ratios cascade through the documents testing a wide range of covenants and baskets. The most important ratios are the various Leverage ratios and the FCCR all of which include by reference EBITDA, the main driver behind an increasing range of grower baskets. In bond (and loan) documents, EBITDA is a defined term and, as such, subject to such adjustments to arrive at the normalised profits or run-rate of the business.
EBITDA is a non-GAAP/IFRS measure primarily used for valuation benchmarking, reporting financial performance and testing covenants in loan and bond documents. The rationale for using EBITDA is that it is a proxy for cash flow and a better measure of the firm’s operation run-rate since it excludes non-operating items such as capex, financing and taxes.
Theoretically these adjustments should be limited to one-off, exceptional or other items designed to reach this outcome, however, benign market conditions have allowed Issuers to introduce increasingly aggressive add-backs undermining this objective. We summarise some of these trends below and also include other ratios and definitions in which Debt Explained has noted increasing flexibility.
- EBITDA add-backs and pro-forma adjustments
Historically, Issuers were permitted to add-back cost savings and synergies in connection with M&A activity. This made sense as these actions often did yield operational benefits although seasoned practitioners might say synergies are like unicorns, we know what they look like but have never seen any. The last year saw an accelerating trend allowing these adjustments to be added back independent of M&A activity (i.e. for any corporate activity including reorganisations or restructurings).
The risk here is that, particularly (but not exclusively) in times of financial distress, Issuers will often implement a wide range of cost cutting measures and synergies but will be able to add these back to EBITDA so masking deterioration in financial performance. This matters to noteholders, especially if the issuer is in distress, since one of the primary advantages of bonds is their ability to trade that enables canny investors to sell their notes, if they anticipate further decline in performance, and avoid significant if not complete value loss.
One further trend seen in 2016 has been that these add-backs are, increasingly, uncapped (or in some cases capped in different ways for M&A on the one hand and other general corporate restructurings on the other hand); this magnifies the risk of concealing deteriorating performance. Finally, it is worth emphasising that Issuers enjoy significant discretion re any add-backs or synergies since these rarely require independent verification and, in most cases, simply are required to be “determined in good faith by a responsible accounting or financial officer”.
- EBITDA based grower baskets
Last year saw increasing use of EBITDA-governed grower baskets in relation to a number of deals, this was particularly prevalent in the case of PE-led transactions and cut across a number of covenants including Restricted Payments (including Sponsor Fees), Permitted Liens and Permitted Collateral Liens.
- Flexible/Fluid Ratios
Not content with “tweaking” EBITDA, Issuers have increasingly varied the definition of ‘debt’ in the leverage ratio particularly in respect of covenants re debt incurrence, dividends, liens and permitted collateral liens and portability. Increasingly issuers have narrowed the definition of debt by referring to “net” rather than “total” debt. By using a narrower definition of debt the Issuer is able to increase debt incurrence, make distributions and even avoid having to make a change of control put to investors.
Issuers this year have continued to narrow the numerator for a leverage ratio, while conversely narrowing the denominator for the FCCR, making it easier for the issuer to meet its ratios. We have seen this across the board with the exclusion of certain types of secured and structurally senior debt in the secured leverage ratio, the exclusion of permitted debt baskets in leverage ratios, and a continued narrowing of the denominator in the FCCR. One example of this is when issuers apply pro forma calculations in a disparate way across different ratios. The leverage ratio might include cost savings and synergies for acquisitions, restructurings, and reorganizations (in and of itself, aggressive), but the FCCR will be more narrowly tailored to include only cost savings and synergies related to acquisitions.
Additionally, Issuers have expanded the use of the Limited Condition Acquisition calculation flexibility in two ways: by expanding the ability to calculate a ratio on the date definitive documents are entered into to the portability ratio instead of the date of consummation, and by expanding the ability to calculate the leverage ratios and the FCCR as of the date definitive documents are entered into for any acquisition or investment, not just acquisitions that are not conditioned on third-party financing.
This is a summary drawn from the full report; High Yield Aggressive Terms 2016. If you are a subscriber to Debt Explained you can log in now to read it. If you would like more information about this report or becoming a subscriber, please contact firstname.lastname@example.org
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