European High Yield Bonds Covenant Degradation: True or False?

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Arnold Parker
5 years ago
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1 European High Yield Bonds Covenant Degradation: True or False? Hermes Credit Breakfast Seminar October 2017

2 Debt Explained: Who are We? Built on robust, fundamental analysis Clarity Granular Unique Detailed analysis on each deal and data is created from the terms 550 data points per bond makes our data the most detailed and granular HYB dataset is 700 bonds, giving us a unique perspective and offering Comprehensive Expert Specialist 2

3 How is High Yield Different to Investment Grade? Issuers more likely to be riskier, more leveraged than Investment Grade (IG) issuers According to Pimco: has potential for price appreciation high yield sector generally has a low correlation to other sectors of the fixed income market along with less sensitivity to interest rate risk, giving portfolio diversification benefits; and historically, has offered similar returns to equity markets, but with lower volatility. Comprehensive Expert Specialist 3

4 Investor Protection Covenant package and restrictions on actions of the Issuer and the credit box are more onerous Should be designed to limit risky behaviour and actions that can lower value of the business Covenant packages not one-size fits all Good and thorough understanding of covenants, especially carve-outs is key for investors Understanding helps investors assessment of adequacy/ compensation for the risk Comprehensive Expert Specialist 4

5 What Covenants/Protections should you expect? Numerous negative covenants (i.e. they shall not do, except ): includes limits on ability to Incur additional debt Provide security over assets of the credit box Pay dividends to shareholders or repay subordinated debt Dispose of revenuegenerating assets and consequences of such disposals Make redemptions prior to maturity Make relatedparty transactions Comprehensive Expert Specialist 5

6 What Covenants/Protections should you expect? and the Positive: affirmative covenants (i.e. they shall do ), including Security and other credit support Bondholders enforcement rights Amendments, waivers and other bondholder matters Comprehensive Expert Specialist 6

7 Private Equity Sponsors and Covenant Degradation The PE conundrum Many PE deals are larg(er), liquid and new but PE and Banks are cosy Drive sponsor-friendly terms from loans to HYB Is HYB now sponsor vs non-sponsor? Comprehensive Expert Specialist 7

8 Debt Incurrence Restrictions: How Does it Work? General prohibition on debt incurrence, subject to carve-outs Any debt if an FCCR coverage test is met - commonly 2x Permitted debt baskets freebie baskets to incur specified categories of debt (including numerous ordinary course type debt), as well as a basket for any type of debt Use of the baskets do not require a ratio test to be met except the acquired/acquisition finance basket Comprehensive Expert Specialist 8

9 Degradation of Debt Incurrence Limits Use of grower baskets Amount of debt that can be incurred and sometimes grand-fathering of existing debt Use of net leverage test Pro forma calculations and EBITDA add-backs/cni exclusions - synergies and cost savings Non-guarantor debt incurrence Comprehensive Expert Specialist 9

10 Dividend/Junior Debt Repayment (Money Out) Limit Limits value extraction by shareholders or ability to take out subordinated debt (including shareholder debt ), or making of certain investments, subject to carve-outs Permitted from a builder basket of 50% of CNI and certain other additions subject to no default and FCCR test Other carve-outs from the restriction not built-up but sometimes subject to no default stopper Annual Sponsor monitoring fees and other advisory services fees Permitted investments Comprehensive Expert Specialist 10

11 Degradation of Money Out Restrictions But weakened.. Ratio-capped carve-out and with increasing leverage, ratios ticking up Carve-out for investments in Unrestricted Subsidiaries, which proceeds will not thereafter be controlled by the covenant (beware) Fewer baskets reduce capacity under the builder basket (what is this?) J-crew trapdoor (what is this?) Additional freebie amount in the builder basket, if conditions for use of the basket are met Payments when a default permitted? Comprehensive Expert Specialist 11

12 Ratio-Capped Restrictive Payments Basket 100% % 80% 70% 60% % % 30% 20% 10% % 1H H H H H H H H H H 2017 Yes No Consolidated Leverage Ratio (average) 0.00 Comprehensive Expert Specialist 12

13 Asset Disposals Limit Aims to protect existing assets from leaving the group, without receipt of adequate value Sale for FMV and 75% received as cash/cash equivalent investments ( C/CE ) Certain asset sales (via carve-outs in the Asset Sale definition) are not restricted by the covenant Proceeds either reinvested or amounts above a specified threshold applied to repay debt Comprehensive Expert Specialist 13

14 Degradation Reversing the Order of Priority? Erosion of the C/CE requirement by designated cash consideration and de minimis threshold Reinvestment not limited to non-current assets Circumvention of the waterfall of proceeds by using proceeds to make Restricted Payments or Permitted Investments - Danger! Comprehensive Expert Specialist 14

15 Redemption Restrictions Typically no right to redeem bonds before maturity, except: after the non-call period at pre-determined prices during the non-call period at a make-whole price equity claw proceeds of an IPO used to redeem a specified % of the bonds (typically 35 40%) at a pre-agreed price Change of Control put at 101% Asset sale offer at par (see above) Comprehensive Expert Specialist 15

16 Degradation of Redemption Restrictions Bonds required to remain outstanding after exercising the equity claw has a gap, allowing redemption of that gap amount at another price The equity claw can be exercised from proceeds of non-ipo offerings, defeating initial reason for provision Portability (comes and goes) and greater flexibility in that calculation Very uncommon, deals requiring bonds to be paid from specified sources, e.g. excess cashflow Comprehensive Expert Specialist 16

industry-recognised criteria User-friendly, rigorous covenant

17 Aggressive Terms Scoring Data-driven analysis of standard aggressive terms Scored against sector and wider market on industry-recognised criteria User-friendly, rigorous covenant assessment designed to suit credit committee Comprehensive Expert Specialist 17

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Envision Healthcare Corporation 8.750% Senior Notes due 2026 Summary. General Terms

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