High Yield Bond Covenants

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High Yield Bond Covenants
Gareth Noonan Director, European High Yield
Capital Markets
CONFIDENTIAL
DRAFT
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High Yield Bonds Structural Overview

• A companys debt capital structure is typically
  divided into several constituencies
• Senior debt
• Subordinated debt
• Senior Debt Usually provided by a bank or other
  lending institution pursuant to a Credit
  Agreement
• Lowest cost
• Variable interest rate
• Secured by all/most assets
• Yearly amortisation of principal
• Maintenance covenants require the company to
  meet 90 ( or -) of its projections
• Subordinated Debt Usually high yield bonds
• Higher cost - compensates for lack of protections
  that senior lenders have
• Fixed interest rate
• Unsecured

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High Yield Bonds Structural Overview
Typical Contractual Subordination
Senior Secured Bank Debt
Parent HoldingCompany
Bondholders agree to turn over to banks
anything they get from obligors until banks are
paid in full
Senior SubordinatedNotes
Senior Secured Guarantees
OPCO
OPCO
OPCO
Senior Subordinated Guarantees
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High Yield Bonds Structural Overview
Typical Structural Subordination
Parent HoldingCompany
Senior Notes
Bondholders claims to assets and cash flow of
business are limited to dividends from Opcos.
Banks wont allow Opcos to pay dividends unless
they know they are covered first
OPCO
Senior Secured Bank Debt
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Why Do Bond Investors Need Covenants?

• Covenants protect bondholders against a
  diminution in value of their investment through
• Credit deterioration
• Loss of equity cushion
• Loss of control over assets
• Loss of seniority position
• Covenants increase the chance of capital gains
  for bondholders because they force the company to
• Deleverage (or, more accurately, limit the
  companys ability to releverage)
• Reinvest earnings
• The typical restricted payments covenant requires
  the company to retain 50 of net income in the
  business and allows 50 to be dividended out to
  stockholders
• As a result, covenants lead to credit improvement
  which increases chance that bonds will trade
  above par

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Who is Subject to Covenants?

• The Company and its Restricted Subsidiaries are
  subject to the covenants, even if the Company is
  the only signatory to the indenture. Each
  covenant begins with the phraseThe Company
  will not and will not permit any of its
  Restricted Subsidiaries to
• Unrestricted Subsidiaries are not subject to any
  of the covenants
• The covenants place a firewall between the issuer
  and its Restricted Subsidiaries, on the one hand,
  and the Unrestricted Subsidiaries on the other
  hand

Issuer
Restricted Group
Restricted Sub
Restricted Sub
Unrestricted Sub
Restricted Sub
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Specific Covenant Issues

• Each deal is different, but in every deal the two
  most important covenants are
• Debt incurrence
• Restricted payments
• Other covenants are less crucial but are
  important too. The other covenants typically
  include
• Change of Control
• Affiliate transactions
• Mergers
• Asset sales
• Anti-layering
• Liens
• Dividend stoppers at subsidiaries
• All of these covenants are incurrence tests
• Whereas maintenance covenants are customary in
  bank deals, failure to maintain specified
  leverage/cash flow ratios will not cause a
  default under a high yield indenture

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High Yield Terms
Covenants Debt Test Ratio Tests

• Restricts incurrence of debt (subject to certain
  exceptions) unless either
• A ratio test is met, or
• A Permitted Debt basket is granted
• There are two possible ratio tests
• Fixed Charge Coverage Ratio(EBITDA/Interest
  Expense)
• Typically 2.0x
• May ratchet up
• Leverage Ratio(Debt/EBITDA)
• Typically around 6.0x
• This is the preferred ratio for media and telecom
  companies
• Purpose of the ratio test is to allow the Company
  to incur more debt as the credit improves
• The ratio tests utilise the Companys EBITDA and
  interest expense over the last four quarters
• Bond covenants do not use projections
• LTM results are adjusted so that they are a more
  meaningful yardstick for measuring the Companys
  ability to service more debt in the future

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High Yield Terms
Covenants Debt Test Adjustments

• Definitions are key (Consolidated Net Income,
  Consolidated Cash Flow)
• Pro forma adjustments to the LTM numbers are
  important
• Typical adjustments include
• Pro forma for acquisitions and divestitures as if
  they had occurred at the beginning of the period
• Pro forma for increases and decreases in debt as
  if they had occurred at the beginning of the
  period
• Eliminating impact of extraordinary items
  Eliminating other unusual items that are not
  indicative of future operations unusual is in
  the eye of the beholder
• Some companies want to more aggressively adjust
  their historical numbers to
• Include anticipated future cost savings from
  acquisitions
• Exclude unusual or nonrecurring charges
• Make other adjustments that would not pass muster
  with the SEC under Regulation S-X

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High Yield Terms
Covenants Debt Test Carve outs

• All debt covenants also include a concept of
  Permitted Debt (which can be incurred even if
  the ratio test cannot be satisfied)
• Will usually be a /euro amount sufficient to
  fund total interest expense for at least 6-12
  months
• Other carve outs
• Bank carve out (with ratchet down)
• Existing debt
• Capital leases
• Inter-company debt
• General basket
• Others

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High Yield Terms
Covenants Restricted Payments

• The purpose of this covenant is to protect
  bondholders access to value by limiting
  undesirable asset transfers such as
• Dividends/repurchases of equity
• Retiring debt that is subordinate to the bonds
  before retiring the bonds
• Investments in entities that are not Restricted
  Subsidiaries

Company
Restricted Group
Third PartyInvestor
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Restricted Sub
Restricted Sub
JV
Restricted Sub
Investments are usually the subject of a separate
covenant in bank deals
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High Yield Terms
Covenants Restricted Payments

• The basic test prohibits all of these asset
  transfers (known as Restricted Payments) unless
• Total Restricted Payments are less than 50 of
  Consolidated Net Income since the closing of
  the high yield deal and
• Company could incur 1 of additional debt at time
  of making the payment
• i.e., Fixed Charge Coverage was 2.0x or higher
  (or Leverage Ratio was 6.0x or lower)
• No default has occurred and is continuing
• Customary exceptions include
• Permitting limited repurchases of management
  equity in connection with stock option plans
• Subject to a dollar cap per annum
• Permitting new equity proceeds to immediately
  flow back out and repurchase old equity or to
  make a restricted investment

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High Yield Terms
Covenants Restricted Payments - Permitted
Investments

• Any investment in the issuer or in a restricted
  subsidiary is permitted
• Any investment in a person, if as a result of
  such investment such person becomes a restricted
  subsidiary
• Any acquisition of assets solely in exchange for
  the issuance of equity
• Others Note these covenants allow issuers to
  make investments (but not pay dividends) even if
  the main basket is negative
• Sometimes limited by including a Permitted
  Business standard

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High Yield Terms
Covenants Change of Control

• This covenant gives each bondholder a separate
  put right at 101 of par if a Change of Control
  occurs
• Bondholders are investing in the existing equity
  sponsor and Board of Directors
• Bondholders want to have the option to exit the
  deal if a new person or group takes over the
  company
• Merger of two public companies may not trigger
  the change of control (unless you have a single
  stockholder or group that controls the surviving
  company)
• The definition of Change of Control may vary
• Typical provision is tripped if
• Any single person or group acquires more than
  35-50 of the companys outstanding voting stock
• Exception for original deal sponsor and entities
  controlled by that sponsor
• A new Board of Directors is elected without the
  blessing of the incumbent board
• Typically not a Change of Control if the
  sponsor sells down to below 50 (or sells out)
  but may be in some cases

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High Yield Terms
Covenants Affiliate Transactions

• This covenant protects against disguised
  dividends by preventing the company from entering
  into non-arms-length transactions with its
  affiliates such as
• Paying excessive management fees to deal sponsors
• Selling assets to stockholders for less then FMV
• Overpaying stockholder/employers through
  excessive salaries
• Affiliate transactions are not prohibited, but
  must be arms-length and approved by
  disinterested directors
• Fairness opinion also required if transaction is
  large enough (involves payments gt5-10M)

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High Yield Terms
Covenants Asset Sales

• The purpose of this covenant is to make sure that
  the Companys balance sheet stays in balance
• Company can sell assets, but must get
• FMV
• Mostly cash (75-85)
• Exception to this for Asset Swaps is common
• Must use the proceeds to either
• Repay senior debt or
• Reinvest in long-term assets useful in the
  business or
• Make an offer to repurchase the bonds
• In other words, if assets shrink, must replace
  with new cash-flow generating assets or reduce
  debt

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High Yield Terms
Covenants Liens and Anti-layering

• Liens
• Protect seniority position
• Senior noteholders dont want more secured debt
  ahead of them -- in particular, they dont want
  the next senior note deal to be secured
• Senior subordinated noteholders dont want liens
  securing any other senior subordinated debt

• Anti-layering
• Prevents issuer from layering debt between the
  senior and subordinated debt
• Only used in senior subordinated deals
• Ensures that subordinated debt occupies the
  second class slot (and not the third or fourth)

Lien and anti-layering covenant issues are
complicated by structures which include second
lien loans and bonds
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High Yield Terms
Covenants Dividend Stoppers

• Dividend Stoppers (Pinching the straw)
• Protects the flow of cash from the subsidiaries
• Dividend stoppers can create structural
  subordination (no access to cash flow)
• Important in holding company deals where bank
  debt is at the operating company

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High Yield Terms
Covenants Merger Test

• Applies to mergers where the issuer is a party
• Does not apply to subsidiary mergers
• Applies to a transfer of all or substantially
  all of the assets
• Bonds should follow the assets
• Prevents the assets from moving as a whole unless
  the credit can handle it
• Merger or sale of all assets okay if
• The surviving entity assumes the bonds
• The surviving entity can incur ratio debt

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High Yield Terms
Covenants Reports Other Covenants

• Reports
• Requirement to make public disclosures of results
• SEC form?
• Quarterly versus semi annual
• Website posting
• Bloomberg
• Bank covenants

• Other Covenants
• Sale/Leaseback
• Sale of equity of subsidiaries
• Additional amounts
• Payments for consent
• Permitted business

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Topics for a Second Meeting

• Subordination and Inter-creditor Issues
• Guarantee Structures and Limitations
• Optional Redemption Terms
• Floating Rate Note Structures
• Senior Secured Notes
• 2cnd Lien Notes
• PIK Note Structures

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