The high yield market has kicked off with a bang again in 2018 but we have slight pause and a chance to reflect. For me it is an opportunity to turn my thoughts to what we can learn from 2017. I should say that my post should be preferred reading for investors - but banned for issuers and their advisers.
Here are my thoughts following the issue of the Debt Explained 2017 High Yield Aggressive Terms compendium (I took out all the complicated bits). I suggest watching out for…
Uncapped add-backs to EBITDA without any third party verification. Given EBITDA is an integral element of every leverage-based calculation with the issuer making such calculations - need one say more?
Different adjustments for calculating different ratios (e.g. pro forma for acquisitions for net leverage calculation but to include disposals and corporate initiatives (whatever they might be) for FCCR). This lack of consistency makes analysis by investors difficult at best.
Adjustments extended from “Limited Condition Acquisitions” to encompass investments, portability, debt and lien incurrence (now referred to as Limited Condition Acquisition flexibility) - great to be able to pick the best date for calculation.
What is indebtedness? A simple question - but no! Issuers are varying the definition and including/excluding different types of debt from different ratios (and so affecting the resulting ratio). Often “indebtedness” for calculation purposes only includes debt secured on noteholders collateral - and then only if pari passu or prior ranking. This masks the true picture and potentially primes noteholders.
Definition content shuffling. For example, by excluding what might be EBITDA add-backs (and defined as such, potentially allowing a cap to be imposed for the benefit of investors) from the CNI calculation there are several consequences including no potential capping, and enhanced Restricted Payments (RP) capacity from the build-up basket. A double dip is also potentially possible.
Contribution Debt dangers - not only is the contribution debt (increased debt capacity when new “equity” injected) ratio creeping above 1:1 but restrictions on the ability to pay out (via RPs) such debt to owners are being lessened.
Increased Restricted Payment capacity via separate leverage-based baskets now very common. Based upon EBITDA calculation where owners hold the pen (see above). RP double dip-payments under the leverage basket do not reduce capacity under the CNI-based builder basket. What a winner!! Free and clear “starter” basket addition to CNI further adds to RP risk. If issuers can reclassify elements of the overall CNI basket, “gaming” is possible via selective timing and selection of carve-outs.
Non-guarantor restricted subsidiaries (NGRS) creditors gaining benefits of noteholders collateral (diluting noteholders) as no secured leverage test requirement for granting of such security. Ouch if things go wrong and you have to share!
Specific purpose lien basket reclassification creates artificial and unintended lien debt capacity.
Portability ratio calculation distorted by using net (not gross) total leverage; not resetting CNI basket to zero allows round tripping of the difference between gross and net.
Trapdoors - good luck finding them, they are often hidden under rugs.
Many of the above are best described as “trending” rather than “market”. But will they move to market in 2018? My guess (which is as good as yours) is no. But we shall see.
For continuing review of “standard aggressive terms” in the market I suggest use of the market benchmark ACTS (aggressive covenant terms scoring) from Debt Explained. Click here for more information. Simple standard criteria (dynamic with the market) allows you to follow the aggressiveness in the market. See my next blog for an overview of YTD, 2017 and 2016. The data does not lie - though it may not always say what you might expect!!
-- Stephen Mostyn-Williams, Chairman of Debt Explained
Stephen founded Debt Explained in 2009, following a 25 year career in leveraged finance. He has held senior positions at Cadwalader, Wickersham & Taft LLP; Shearman & Sterling LLP and Ashurst. Stephen co-founded the European High Yield Association and served as its chair for the first three years of its existence.