Since the inception of the financial crisis in 2007-08, the acquisition and corporate finance market has witnessed two major phenomena: a significant reduction in western banks’ lending appetite and the absence of new collateralised loan obligations (CLOs) vehicle issuance.
Although this new state of play has generated a liquidity squeeze for corporations it has also presented an opportunity for high-yield (HY) bonds – defined as bonds rated below BBB-/Baa3 – to take a larger share of the leveraged finance market. Issuance of HY bonds increased to €35bn in 2011, up from €2.6bn in 2008 and €25bn in 2009.
HY was developed decades ago in the US and its growth in Europe has been driven primarily by refinancings of corporate issuers – typically BB/Ba ratings and above – and the increasing inflow of capital that institutional investors want to dedicate to this asset class.
While not all companies can issue HY bonds, as the minimum issuance size tends to be around €200m and companies need to be generating about €50m of earnings before interest, tax, depreciation and amortisation (EBITDA), this financing tool offers attractive characteristics to management teams seeking to benefit from more flexible terms than those traditionally on offer with loans.
The main attractions of bonds include:
- Fixed coupons: Interest rates are set at time of issuance and are influenced by the quality of the borrower (or credit); the leverage level – net debt/EBITDA – of the borrower; and the state of the macroeconomic environment.
- Bullet repayment: HY bonds are repaid at maturity; issuers only have the obligation to comply with half-year interest payments and cash build-up therefore offers further operating flexibility.
- Covenants: HY bonds are issued with ‘incurrence covenants’. Compliance with a fixed charge cover ratio (typically pro-forma EBITDA/interest) and a senior secured indebtedness ratio (when senior secured debt is incurred) only have to be complied with if or when the borrower incurs additional debt.
- Acquisition flexibility: HY issuers are allowed to carry out further acquisitions as long as they comply with incurrence covenants; they can also use the super-senior revolver facility, as well as surplus cash, for the purpose of acquiring relevant targets.
- Dividends: HY issuers can pay dividends to their shareholders for an amount equivalent to 50% of the consolidated net income.
- Lighter due diligence: HY investors do not request costly bespoke due diligence reports.
These features allow HY issuers to benefit from a flexible financing tool, which enables them to continue to grow their company while adjusting liquidity management to market conditions and cyclicality.
The HY Issuance Process
Issuance of HY financing comes only after a bespoke process that includes the preparation of an offering memorandum, public rating of the borrower and a marketing road show.
HY bonds are publicly listed financing tools typically issued under New York law; the first were issued in New York and US-based investors still influence this field. As such, they can only be issued after the mandatory issuance of a detailed offering memorandum sent to all potential investors. The offering memorandum is essentially drafted by legal counsels and must include the historical financials of the company (no projections made available) audited less than 135 days before the actual issuance, an industry and market overview, the business overview, the main risk factors to the business and its investors, key legal characteristics of the offer and the resulting capital structure.
Bonds also have to be assigned credit ratings by reputable agencies. Issuance of these ratings takes between four to six weeks and reflects the credit risk of the company/facilities, on the basis of the business model, the sector dynamics, the financial model and the capital structure contemplated by management.
Finally, HY bonds are raised through a ‘book building’ exercise, which requires management to mount a road show that presents the company and the rational/merits of the contemplated new capital structure to investors.
Guidance Through a Complex Process
Preparation of these main work streams is demanding for management teams and requires the production of copious amounts of financial, corporate, legal and market information. Such preparation over a compressed timeframe, as short as six weeks in some cases, can be heavily disruptive to management teams who also have to negotiate commercial and legal terms of their new financings. This is why the use of advisers is advantageous, particularly for first-time issuers.
From personal experience, management teams accustomed mainly to loan financings need rigorous education on the covenants and reporting criteria. They require help to prepare the commercial negotiations (including ‘baskets’, guarantors, security package and covenant definitions), and select the relevant issuing banks and legal counsels. Advisers tend also to be instrumental in the preparation of the financing model and ratings agencies presentation and usually co-ordinate the offering memorandum drafting process. They also need proactively to be preparing alternative financing solutions in case the HY market closes momentarily.
If the HY product is here to stay, as seems highly probable, the apparently random open/shut nature of the primary market, caused by current unstable macro-economic conditions, reinforces the need for independent experts to balance conflicted advice sometimes on offer. This will ensure that each company is ready to launch its new bond whenever a ‘window of opportunity’ opens.
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