Financial Covenants. Moderator: Dan Papermaster, Morgan Lewis & Bockius LLP

Transcription

1 Financial Covenants Presented by: Patti Boss, Voya Investment Management LLC Matt Gabrys, The Northwestern Mutual Life Insurance Company Sasha Kamper, Principal Global Investors LLC Moderator: Dan Papermaster, Morgan Lewis & Bockius LLP ACIC 2016 Spring Investment Forum April 8, 2016

2 PRIVATE AND PUBLIC COVENANTS 2

3 Public Investment Grade: Suggested Model Covenants Background: In 2007, recognizing a lack of protection in the standard Investment Grade covenant packages, a group of Investment Grade investors assembled to identify deficiencies and establish model covenants Model Covenants: Change of Control Step-Up Coupons Limitations on Liens and Priority Debt Reporting Obligations Voting by Series 3

4 Public Investment Grade: Covenant Trends Change of Control 70% 60% 50% 40% 30% 20% 10% 0% Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan % 90% 80% 70% 60% 50% Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Source: Covenant Review Limitations on Liens Market capitalization, credit quality and event risk are the main drivers of inclusion Two step process with triggers that have stable degrees of adoption Covenant is widely adopted with quality of protection fairly stable Largest adoption of covenant has been in lower quality Investment Grade names 4

5 Public Investment Grade: Covenant Trends Coupon Step-Up Provision Proposal is based on +25bps per downgrade, per agency, maximum of 2% step-up. It has been a limited adoption by issuers. Ex: Avon, Staples, ArcelorMittal Reporting Obligations Public disclosure of financial statements and management commentary regardless of SEC requirements Not confined to specific sectors or particular credit quality of issuer Voting by Series Voting on indenture amendments or waivers by individual series of bonds, rather than by class Adoption has been steady at about a 60% level, regardless of credit quality or market capitalization Additional Covenant Trends Adoption of additional covenants has been limited, with overall trends less bondholder friendly More High Yield crossover issuance reflecting Investment Grade covenant packages 5

6 Private Investment Grade: Covenant Overview Common Covenants Prevalence in Market* 1. Maintenance Financial Covenant Ratios 2. Change of Control 97% had at least 1 test Average deal had ~2 tests 65% had a coverage test (EBITDA / Interest > 3.0x, on average) 59% had a Debt / EBITDA test (3.3x, on average) 84% with prepayment trigger, typically at par 3. Priority Debt Limitation 4. Asset Sale Limitation 98% restricted to a basket, typically 10% of assets 85% restricted to a basket, typically 10% of assets per year * Based on sample of 10 NM deals each year from (110 total deals) 6

7 Private Investment Grade: Covenant Trends A Tests Have Been Fairly Consistent Over Time, and Through a Cycle Year Deal Chg. of Control MFL Debt / Cap Coverage Leverage Net Worth Anti- Cookson * Based on sample of 10 NM deals each year from (110 total deals) 7

8 Private Investment Grade: Covenant Trends B Levels Have Been Fairly Consistent Over Time, and Through a Cycle * Based on sample of 10 NM deals each year from (110 total deals) 8

9 Private Investment Grade: Covenant Trends C Covenants Have Been Fairly Consistent Across Multiple Issuances CoC MFL Debt/Cap Coverage Leverage Priority Debt Anti-Cookson Sale of Assets Evolution Issuer MW Yes 4.00x 3.00x 5% CTA GBP 20mm 2009 MW Yes 4.00x 3.00x 5% CTA GBP 20mm Issuer Par 2.50x 3.50x 15% CTA Yes 15% CTA 2014 Par 2.50x 3.50x 15% CTA Yes 15% CTA Issuer Yes 30% CTA 2014 Yes 30% CTA Issuer Par 3.00x 3.50x 15% CTA Yes 10% CTA x 3.50x 15% CTA Yes 10% CTA Issuer Par 3.00x 15% CNW 15% CTA 2008 Par 4.00x 3.00x 15% CNW Yes 15% CTA Issuer Par 3.50x 3.75x 10% CTA Yes 10% CTA 2012 Par Yes 3.50x 3.75x 10% CTA Yes 10% CTA Issuer Par Yes 3.50x 35% Assets Yes 10% Assets 2010 Par Yes 3.50x 35% Assets Yes 10% Assets Issuer x 10% CTA Yes 25%NTA x 10% NTA Yes 25% NTA Issuer Par 50% 2.50x 20% CNW Yes 15% CTA 2015 Par 2.50x 3.50x 15% CTA Yes 15% CTA Issuer Par 75% 1.50x 10% CTA Yes 15% CTA 2014 Par Yes 75% 10% CTA Yes 10%CTA 9

10 Example: Issuer Migrating from Private to Public Market 2005 Private Placement (Internal: Baa1) 2010 Public Notes (Baa3, BBB-, NR) Change of Control Prepayment at par Net Worth Covenant Leverage cannot exceed 3.5x Priority Debt cannot exceed 20% of Consolidated Adjusted Net Worth Cannot sell more than 25% of Consolidated Total Assets/year Change of Control Prepayment at 101% Limitation on sale/leaseback transactions Secured Debt cannot exceed 15% of Consolidated Net Assets (with anti- Cookson protection) Lien sale/leaseback transaction basket of 20% of Consolidated Net Tangible Assets 10

11 Conclusion Public market opportunity substantially larger and growing Private markets offer clear benefits: Unique issuers Geographic diversification Strong and valuable covenant protection 11

12 PRIVATE PLACEMENT COVENANTS: Maintaining Bank Parity 12

13 Bank Parity Case Study: Freeport McMoRan, Inc. Copper miner, Freeport McMoRan, purchased two oil & gas exploration & production companies for ~$20bb in 2013, financed mainly with debt. Intent was to de-lever, but... 12/31/15 Leverage = 5.7x and ratings dropped from Baa3/BBB-, at issue, to B1/BB today. Leverage could grow to high single-digits, if copper and oil prices remain depressed. Current capital structure: $14.7billion in Public Bonds $4.75 billion Term Loan $3.5 billion Revolver 13

14 Bank Parity Case Study: Freeport McMoRan, Inc. Bank Facilities had financial covenants to protect downside, and negotiated an amendment If Freeport cannot effect a material asset sale in 2016, then the Term Loan and Revolver will take security/subsidiary guarantees. Public bond protections are weak: - No financial covenants - Weak Negative Pledge/Subsidiary Debt protections 14

15 Bank Parity Case Study: Freeport McMoRan, Inc. Public Bond Negative Pledge: We will not, nor will we permit any Domestic Subsidiary to, incur, issue, assume or guarantee any Debt secured by a Lien upon any Principal Property or on any shares of stock or Indebtedness of any Domestic Subsidiary... Principal Property Definition:... a single oil, gas, metal or other mineral property (other than inventory or receivables),... which has a net book value in excess of 2.5% of Consolidated Net Tangible Assets... 15

16 Bank Parity Case Study: Freeport McMoRan, Inc. Subsidiary Guarantor Clause: If any subsidiary of Freeport McMoRan Oil & Gas... becomes a borrower or guarantor under any obligations pursuant to (1) any Freeport McMoRan Oil & Gas Debt or... (2) any... bank credit facility of Freeport McMoRan... then such subsidiary will guarantee the [public bond] notes... Conclusion: Banks can easily demand security in working capital, or take guarantees from Freeport s mining operations, to subordinate public bondholders. Pricing Implications: Freeport McMoRan Public Bonds of 20: $80.75 Freeport McMoRan Term Loan of 20: $

17 Bank Parity Case Study: Freeport McMoRan, Inc. Fixed Income investments have an asymmetric distribution of returns Investors win by avoiding losers, rather than picking winners (i.e. Manage Downside Risk!) 17

18 Covenants: Bank Parity Elements Three key NPA tools to maintain bank parity: Subsidiary Debt/Guarantor protections Anti-Cookson language Priority Debt protections 18

19 Covenants: Subsidiary Guarantor Protections Subsidiary Debt/Guarantor Protections: In the good ole days, private placements had minimum subsidiary guarantees... Now we typically only receive what the banks receive Creates enforceability issues, particularly in foreign jurisdictions 19

20 Covenants: Subsidiary Guarantor Protections If we accept that the new standard is market, then we should focus on three key areas: NPA language should protect against both Subsidiary Guarantors and Subsidiary Obligors Parity in fees, for Release of Subsidiary Guarantors How to effectively track Subsidiary Guarantors and Obligors? 20

21 Covenants: Subsidiary Guarantor Protections Subsidiary Guarantors & Obligors Language: Inadequate: The Company agrees that so long as any Subsidiary is a guarantor under or with respect to any Principal Bank Facility, such Subsidiary shall at all such times be a Subsidiary Guarantor of the Notes. Preferred: The Company agrees that so long as any Subsidiary is a borrower [aka obligor] or guarantor under or with respect to any Principal Bank Facility, such Subsidiary shall at all such times be a Subsidiary Guarantor of the Notes. 21

22 Covenants: Subsidiary Guarantor Protections Fee Parity Language: Example: At the election of the Company... any Subsidiary Guarantor may be discharged from its obligations and liabilities under its Subsidiary Guaranty Agreement and shall be automatically released from its obligations thereunder... provided that (i) after giving effect to such release, no Default or Event of Default shall have occurred and be continuing, (ii) no amount is then due and payable under such Subsidiary Guaranty, (iii) if in connection with such Subsidiary Guarantor being released and discharged under any Principal Bank Facility, any fee or other form of consideration given... for such release, the holders of the Notes shall receive equivalent consideration... 22

23 Covenants: Subsidiary Guarantor Protections How to Track Subsidiary Guarantors/Obligors?: Issuers often fail to comply with Subsidiary Guarantor/Obligor covenant. Especially true in cross-border deals Sometimes investors learn of Subsidiary Debt/Guarantees too late Should the Compliance Certificate provide a list of all outstanding Subsidiary Obligations and Guarantees, in addition to a statement delineating which are new? 23

24 Covenants: Anti-Cookson Protections Anti-Cookson Premise: If the banks become secured => Private Placement Notes are secured Example: The Company will not, and will not permit any Subsidiary to, grant any Liens securing Indebtedness outstanding under or pursuant to any Principal Bank Facility pursuant to this Section 10.4(s) unless... obligations of the Company under this Agreement and the Notes shall concurrently be secured equally and ratably... 24

25 Covenants: Anti-Cookson Protections Anti-Cookson Considerations: Not all Anti-Cookson clauses are created equal. Definition of the Principal Bank Facility (aka Material Credit Facility) is key to understanding the degree of protection - Weak Form - Strong Form - Something in between 25

26 Covenants: Anti-Cookson Protections Weak-Form Definition: Covers only the existing banking agreement and any refinancings thereof (no additional facilities or debt is covered) Example: Principal Bank Facility means that 800,000,000 Revolving [or Term Loan] Facility Agreement, dated MM DD, YYYY, made among the Company and XYZ Bank... as the same may be amended, supplemented, or modified from time to time, and any successor, replacement, or supplemental syndicated credit facility or bilateral credit facility of the Company... entered into to refinance, replace or supplement the foregoing. 26

27 Covenants: Anti-Cookson Protections Strong-Form (Preferred) Definition: Covers the existing banking agreement and any refinancings plus any additional facility above a certain size threshold Example: Principal Bank Facility means that 800,000,000 Revolving [or Term Loan] Facility Agreement, dated MM DD, YYYY, made among the Company and XYZ Bank... as the same may be amended, supplemented, or modified from time to time, and any successor, replacement, or supplemental syndicated credit facility or bilateral credit facility of the Company... entered into to refinance, replace or supplement the foregoing, in addition to any other syndicated credit facility, bilateral facility, or bank facility of 200,000,000 or more in size. 27

28 Covenants: Anti-Cookson Protections Other Principal Bank Facility Definition Considerations: If a borrower refinances into multiple facilities, would the definition cover all refinanced facilities, or just the largest of the refinanced facilities? Does the definition cover non-bank debt? (e.g. Existing Private Placement Notes or Public/Medium Term Note debt) An issues memo should address: Whether an Anti-Cookson clause is present in the Note Purchase Agreement Opine on the robustness of the clause 28

29 Covenants: Priority Debt Protections Priority Debt Considerations: Priority Debt Basket size should be thoughtfully considered Both the basket threshold size and the benchmark are important Which is better: 10% of Total Assets or 15% of Net Worth? Different benchmarks may be appropriate, depending on the borrower and the industries that it serves. Percentage of Tangible Net Worth when borrower is acquisitive or has R&D-intensive business? Some borrowers aggressively sizing the Basket 10% of Total Assets is standard, but seeing more proposals for 15-20% of Total Assets 29

30 Covenants: Priority Debt Protections Priority Debt Considerations: Carve-outs are important and deserve analysis Boiler plate carve-outs may not be appropriate in certain industries (e.g. workmen s liens and performance bonds for Engineering & Construction companies) Carve-outs, such as liens due to securitizations, should be eliminated or capped Recently saw a German company that tried to carve-out Statemandated liens on its pension plan from the Basket Unusual or potentially large carve-outs should be highlighted in the issues memo 30

31 Covenants: Priority Debt Protections Priority Debt Considerations: Priority Debt Test has historically been a Maintenance Test, but we re seeing some NPAs where it is drafted as an Incurrence Test Incurrence-based Priority Debt Test wouldn t be tripped if: Borrower sells assets within the context of the asset sales basket Declining business model results in a material asset impairment Incurrence-based Test is not market and should be highlighted in the issues memo 31

32 PRIVATE PLACEMENT COVENANTS: Sale of Assets Test 32

33 Sale of Assets Test Case Study 1: Electricity and Gas Retailer Australian electricity and gas retailer sold its interest in a gas plant for cash consideration of ~A$1.78 billion. Book value of asset was ~A$220 million. Sale of Assets test based on book value: The Obligors will not, and will not permit any Subsidiary to, sell, transfer, or otherwise dispose of any of their properties or productive assets (collectively, a Disposition ), except [various carve-outs] and other Dispositions, provided that any such Disposition is for fair market value and the aggregate book value of the properties and assets subject to all such Dispositions pursuant to this clause during any period of twelve consecutive months would be less than 15% of Consolidated Total Assets determined as of the last day of the immediately preceding fiscal year of the Group.. 33

34 Sale of Assets Test Case Study 1: Electricity and Gas Retailer Using book value, the Sale of Assets test was not violated. Noteholders received a tender offer at less than full Make-Whole with cash proceeds. Proceeds were split between equity and the debt tender, but, without a breach, all proceeds could have been used to pay equity holders. 34

35 Sale of Assets Test Case Study 2: Packaging Manufacturer Large packaging manufacturer in an emerging market. Selling multiple properties via sale/leaseback. Book value of properties is ~$32 million. Selling price estimated at ~$130 million. Sale of Assets test based on book value: The Guarantor will not and will not permit any Subsidiary to, directly or indirectly, sell, lease, transfer or otherwise dispose of (each, or any combination thereof, being a Disposition ) any of its assets unless, after giving effect to such proposed Disposition, the aggregate net book value of all assets of the Group that were the subject of Dispositions made during the 365-day period ending on the date of such proposed Disposition does not exceed 5% of Consolidated Total Assets (to be determined as of the last date of the semiannual financial period then most recently ended), provided that the following Dispositions (or portions thereof) shall not be taken into account. 35

36 Sale of Assets Test Case Study 2: Packaging Manufacturer Using book value, the Sale of Assets test will not be violated. If the test used market value (measured as the amount of net proceeds), the covenant would be breached. Noteholders would like to make sure that proceeds are applied to debt reduction. 36

37 Sale of Assets Test Recommendation Historically book value may have been used as the covenant benchmark because it is easy to reference. Industry should consider moving towards testing the greater of book value or fair market value. Suggested language (with Disposition Value below being defined as book value): 37

38 Sale of Assets Test (g) other Dispositions for cash to the extent the higher of the Net Proceeds of such Disposition and the Disposition Value of the property Disposed of in such Disposition, when aggregated with the higher of the Net Proceeds and the Disposition Value with respect to all other Dispositions made by the Company and its Subsidiaries pursuant to this clause (g) in the same fiscal year of the Company in which such Disposition is made, does not exceed an amount equal to [15]% of Consolidated Total Assets (as measured on the last day of the then most recently ended fiscal year of the Company), provided that, in the event that some, but not all, of the Net Proceeds of a Disposition are applied in accordance with clause (f) above, only the portion of the Net Proceeds that are not so applied in accordance with such clause (f) (or, if higher, a proportionate amount of the Disposition Value of the property Disposed of in such Disposition) shall be counted towards and included in the calculation set forth in clause (g) above. 38

39 Sale of Assets Test Other Items to Consider Consider the industry when measuring against a percentage of total assets e.g., in a service-based industry or a company with a significant amount of intangible property, the test shouldn t be measured against tangible assets. Safe harbor for payment of senior debt should include a requirement that any such payment be a permanent retirement of senior debt (otherwise asset sale proceeds could be used to pay outstanding debt under a revolving line of credit and the company could later reborrow under the revolver). Safe harbor for payment of senior debt should also specify that the debt cannot be owing to the company, any subsidiary or any affiliate. 39

40 Sale of Assets Test Other Items to Consider An issues memo should address any inadequacies described above. Example of Weak-Form Definition of Asset Sale Safe Harbor for Debt Repayment: the repayment of outstanding unsubordinated Indebtedness of the Company or any Subsidiary (other than any Indebtedness owing to the Company or any Subsidiary); provided that any such repayment or prepayment of Indebtedness shall at or about the same time include an offer Repayment of debt owing to Affiliates is allowed permitting, for instance, a shareholder of the Company to be repaid for a shareholder loan No requirement that there be a permanent reduction of debt 40

41 Sale of Assets Test Other Items to Consider Example of Strong-Form (Preferred) Asset Sale Safe Harbor for Debt Repayment: notwithstanding the foregoing, the Company may, and may permit any Subsidiary to, make an Asset Disposition and the assets subject to such Asset Disposition shall not be subject to or included in the foregoing limitation to the extent that [the net proceeds from such Asset Disposition are] applied to the payment or prepayment of the Notes or any other outstanding Indebtedness of the Company and its Subsidiaries that is not subordinated to the Notes (other than Indebtedness owing to the Company, any Subsidiary or any Affiliate), provided that (i) if any such Indebtedness permits reborrowing by the Company or such Subsidiary, the commitment to relend is permanently reduced by the amount of such payment, and 41

42 PRIVATE PLACEMENT COVENANTS: Other Covenant Issues 42

43 Covenants: Other Issues Change of Control Two Types of Change of Control Covenants: 1-pronged Test: Requires only a change of ownership to trigger a Change of Control 2-pronged Test: Requires both a change of ownership and a ratings downgrade, within a set time period, to trigger a Change of Control Prefer the single-pronged test, as the 2-pronged test can potentially be manipulated. 43

44 Covenants: Other Issues - Definitions Definitional Differences are Important: Definitional deviations can bring Private Placement investors and the banks to the table at different times Focus on definitions that comprise part of the key financial covenant calculations (Indebtedness, EBITDA, etc.) Definitions should be compared against the Bank Credit Facility Agreement Any differences should be highlighted in the issues memo 44