Notwithstanding the economic turbulence in the Euro zone, the first quarter of 2012 saw a significant rise in high yield offerings in Europe (a reported increase of four times over the last quarter of 2011). With new regulatory constraints on banks limiting the availability of bank credit facilities in Europe, the European high yield market, despite its continuing volatility, has filled many of the gaps left by the weakness of the bank financing market.
The structures of many European leveraged financings have had to change to accommodate the increasing replacement of bank term debt with high yield notes in transactions. The high yield investor base has also become more vocal over the last year or two, with calls for more comprehensive disclosure and reporting to high yield investors, particularly of the complex intercreditor arrangements that have come with the new structures. Although the high yield windows may open and shut with inexplicable rapidity, it appears that the structural changes and the vocal investor base are here to stay. This article considers some of those structural changes, the current investor requests and their respective implications for private equity sponsors.
Evolving Market Practices: Until recent years, many European high yield notes were either issued on a senior subordinated basis (and so contractually subordinated) or on a senior basis by a holding company and with limited credit support from operating companies (and so structurally subordinated). High yield notes were often unsecured or only benefited from a limited security package often provided only by holding companies. More recently, however, many high yield notes transactions in Europe have benefited from enhanced structural protections and security. Indeed, in 2011 almost half of all European high yield issuances were secured. In many cases, security has comprised security from operating companies and not just holding company or “structural” security.
As the market continues to develop, three core structures appear to be taking centre stage in Europe along with the more traditional subordinated structures: pari passu bank/notes transactions, “super senior” structures and SPY notes structures. If properly executed, these alternative structures provide high yield noteholders with enhanced protections whilst preserving for private equity sponsors and issuers the operational and future financing flexibility that are so important to them.
The Pari Passu Bank/Notes Structure: In one recently emerged structure, traditional bank term and revolver debt is combined with high yield notes, with the high yield notes and bank debt ranking pari passu in right of payment and security and sharing a common security package. While the bank debt and notes rank pari passu, until recently, banks have retained control over enforcement and collateral decisions via intercreditor agreements, giving borrowers comfort that they will be able to continue to deal primarily with their “relationship” banks, particularly in stressed scenarios. However, increased rumblings from the high yield investor community in Europe about the differing treatment of their notes even in apparently “pari passu” structures, particularly with respect to enforcement, have resulted in noteholders gaining increased voting power over the last year. In several deals, noteholders were granted rights to enforcement control when the notes represented a particular threshold amount of the secured debt (typically 70% to 75%). In another model, both bank and bond creditors are able to vote from closing, but with the noteholder vote capped to a low percentage of the overall vote until the notes represent a significant proportion of the overall debt (e.g., 66.6%).
More recently, in the February 2012 issuance by Schaeffler, noteholders in a pari passu bank/notes structure were granted rights to a proportionate vote with the bank creditors, on a €1 equals one vote basis. At the time, this was heralded as a breakthrough for European investors with some commentators going as far as to say that proportionate voting for senior secured noteholders would become the new paradigm. Reports from recent meetings between the Association for Financial Markets in Europe (AFME) and the Loan Market Association (LMA) suggest that, at least informally, the LMA and AFME have agreed that commensurate voting rights for senior secured noteholders is the best way to proceed (though these reports have not been confirmed by any formal announcement by the LMA or AFME). The market is still evolving on this front and, depending on the ratio of bank and bond debt, this trend has the potential to enhance significantly the negotiating power of noteholders when seeking changes to the security structure and during any restructuring discussions with a private equity sponsor.
The “Super Senior” Structure: A second structure, known as the “super senior” structure, has emerged where banks provide only senior secured revolving facilities, with the “term” debt financing comprised solely of high yield notes. In this structure, the notes effectively take the place of the term debt traditionally incurred to finance the acquisition and/or refinance existing debt. In these transactions, the revolving credit facilities usually make up a relatively small portion of the capital structure and are documented under a traditional credit agreement. However, the covenants are predominantly “incurrence” based, mirroring those applicable to the high yield notes (although sometimes with additional limited financial covenants such as a leverage covenant and/or an interest coverage covenant), and the defaults are similar to those seen in high yield financings. These more flexible covenants and defaults are much more advantageous from issuer and sponsor perspectives.
In the super senior structure, the revolving facilities obtain their super senior status by ranking ahead of the senior secured notes (and, in some cases, any term bank debt) in the enforcement waterfall—i.e., they are paid first from the proceeds of security enforcement. Unlike in most pari passu bank/note deals, the notes generally control enforcement subject to increasingly familiar and formulaic security enforcement principles. These principles and the intercreditor arrangements generally can be expected to contain restrictions on the amount of time in which enforcement must be completed and assets realised (4 to 6 months is typical). In addition, they will likely provide for fair value protections for the revolving facilities, often in the form of fair sale opinions, and sometimes require that proceeds from a distressed sale be sufficient to repay any revolving facility outstandings in full (leaving borrowers to deal only with the noteholders on any restructuring). Noteholders often also require a purchase right, enabling them to purchase outstanding revolving facility debt at par, and, thus, providing them with another enforcement option.
The SPV Structure: A third structure has emerged in refinancings to address consent issues raised by European bank deals. In this structure, the proceeds of notes issued by a special purpose vehicle are used to finance a new tranche under a credit facility, which in turn is lent into the borrower group to refinance existing debt. This structure utilises the “facility change” mechanism common in European credit agreements and so is generally used to obviate the need to obtain the unanimous consent of existing credit facility lenders that would otherwise be required to raise the new debt.
Disclosure: The last twelve months have also seen an increasingly organised high yield investor base in Europe call for enhanced disclosure in offer documents, increased access to underlying transaction documents (including the making available in a public forum such as the issuer’s website of material debt facilities, intercreditor agreements and amendments and waivers in respect of the same), enhanced financial disclosure and improvements to covenants in respect of ongoing disclosure (including conducting investor calls after publication of quarterly and annual accounts). With increasingly complex structures in which the notes often obtain senior guarantees and security from the operating group, there are also requests for improved disclosure in respect of group structures and ongoing reporting in respect of changes to the group. These requests have often been accommodated, and many recent European high yield transactions provide for enhanced initial and ongoing disclosure.
Observations
From a private equity sponsor perspective, although the incurrence based covenants of a high yield offering are very advantageous, the new structures have brought with them challenges. Among those challenges are: the absence of a core group of relationship banks to provide any necessary consents to required changes to financing terms, the need to obtain separate working capital and revolving facilities, and the maintenance of an acceptable level of reporting and confidentiality of sensitive business terms in the face of investor expectations for increased transparency. Private equity sponsors and issuers have also been focused on the need to maintain future financing flexibility to make operational business changes within the constraints of such complex and comprehensive secured high yield financing structures. Legal regimes in Europe can make it difficult to accommodate future secured debt within an existing secured financing structure without revisiting the initial security package and documentation. However, the increasing number of European high yield financings utilizing these new structures suggests that the challenges which they present can be managed to accommodate sponsor needs.
Although the European high yield market is likely to remain very volatile, the continuing weakness of the European bank market is likely to drive private equity sponsors and underwriters to continue to develop structures to facilitate leveraged acquisitions where all or a majority of the debt financing is provided by the high yield market. Some European companies, particularly seasoned issuers, have turned to the deeper (as of earlier this spring) U.S. high yield market during turbulent periods in Europe, and the new structures may facilitate the issuance of high yield notes in that market as well.