European High Yield June Wrap-Up: The Turning Tide—Has Market Volatility Stabilized Covenant Erosion?

This year kicked off with a dramatic battle of wills over the scope of fundamental covenant protections, and by the midpoint of 2018 negotiating dynamics had solidly shifted in favor of investors. Covenant Review’s preliminary findings revealed that nearly a third of deals have priced with covenant amendments so far this year. In the second quarter alone seven deals were postponed—a record number for a single quarter. There are many factors driving these developments, but a single theme ties them all together—increased engagement and greater transparency are transforming the European high yield market.

Covenant Review explored this evolving state of affairs during the first seminar in our Evolution of Covenants series, presented together with the Association for Financial Markets in Europe (AFME). The room was filled to capacity on the day, illustrating what an important issue this is to the market. We had experts on the panel representing legal, sell-side, buy-side, and private equity, reflecting the views of all parties at the table during the European high yield sales process.

The panel discussed the offering process from structuring through pricing, offering insights into how the negotiation process currently works, and how it might be improved. Covenant Review is proud to support the market by stimulating active discussions of covenant protections in many ways, including hosting events like this to facilitate engagement on these important issues.

In October we will host the second seminar in the series, presented as the opening event to AFME’s 13th Annual European High Yield conference. We will explore in detail how covenants have evolved throughout this year, analyzing to what extent the current complex macro-economic backdrop is helping to stem the tide of covenant erosion.

June’s high yield offerings included two pulled deals and two deals pricing with extensive covenant amendments. Meanwhile, the BB+ space continued to illustrate the favorable terms available to borrowers on the cusp of an investment grade rating, with two issuers pricing covenant packages with a mix of investment grade and high yield covenant provisions.

Salt and Synthomer both pulled deals due to price sensitivity this month. We noted in a Market Alert that Salt’s refinancing transaction would open up a host of covenant flexibility achieved in its November 2017 issuance once the older, more restrictive bonds were repaid. Investors indicated to Covenant Review that they had priced in a premium for the increased flexibility, which may have contributed to Salt’s decision to pull the deal, citing market conditions, late in the first week of the month.

InterXion’s €1 billion of senior notes due 2025 priced at the wide end of guidance, reflecting in part a covenant package that was notably missing Restricted Payments, Affiliate Transactions, and Dividend Stoppers covenants. Investors revealed to Covenant Review that the coupon for the BB- rated issuance priced in around 75 bps for the flexibility, demonstrating that while investors are unwilling to accept significant covenant flexibility without some compensation, issuers who are willing to pay for that flexibility can find a price in the market.

International Gaming Technology (IGT) and Smurfit Kappa each came to market with similarly sparse covenant packages, a continuing trend in the BB+ space. IGT’s bonds priced at the wide end of talk but cheaper than the debt being refinanced, while Smurfit Kappa upsized its offering of senior notes from €500 million to €600 million, and priced at 2.875%, inside of the 3%-area IPT.

The third week of June demonstrated the strength of European high yield investors’ negotiating leverage, as both Cirsa and TDC printed extensive amendments to what were initially very issuer-friendly preliminary covenant terms. In the same week, Energizer’s comparatively middle-of-the-road covenant package backing the company’s acquisition of Spectrum Brands sailed through primary without changes and tight of talk.

TDC’s dual currency €1.4 billion equivalent of senior notes due 2023 contained dividend capacity that would have significantly increased the risk of value leakage, as we noted in a Market Alert published at launch. The leverage-based Restricted Payments carveout would allow the issuer increased capacity if it was rated B1/B+, an off-market feature that—counter-intuitively—would have permitted TDC to take actions following an increase in the rating of the Notes that could result in a decrease in the rating of the Notes. Redemption provisions included a 10% at 103% option, an issuer-friendly feature very uncommon for an unsecured offering.

In our full report on the preliminary terms for the notes, we highlighted other risks, including the potential for increased capacity across the covenant package though uncapped EBITDA add-backs for synergies, including costs for rebranding, business optimization, information technology implementation or development, and any telecommunications capacity related or similar fees, alongside any restructuring-related costs.

Revised provisions circulated with final pricing terms addressed these points, and others. The step-up feature for uncapped Restricted Payments was dropped. The 10% at 103% redemption flexibility was axed. EBITDA add-backs are now subject to a cap. Together with a raft of other documentary amendments and clarifications, plus the incorporation of some of the asset sale restrictions included in the TLB, the overall protection afforded to investors was significantly improved.

Cirsa launched a €1.56 billion seven-year bond package backing its takeover by Blackstone. In our report analyzing the preliminary terms for Cirsa’s covenants, we noted the significant capacity to pay dividends and invest in entities outside of the reach of the covenants. The Restricted Payments covenant included a leverage-based Restricted Payments carveout that would permit uncapped dividends to a pro forma net leverage ratio set in line with opening leverage. The provision would have allowed Cirsa to ignore certain debt, make significant pro forma adjustments, and/or cherry-pick when it calculated the ratio. The Change of Control provisions contained a portability exception, arguably unnecessary in a covenant package backing an issuer’s acquisition by a private equity sponsor. The deal also featured a 10% at 103% redemption provision.

Revised terms addressed these points, and other documentary risks. The leverage-based Restricted Payments carveout was reduced by a turn of EBITDA, so will now require meaningful delevering before dividend capacity can accrue. Other Restricted Payments basket capacity was also axed. The risk of significant (and uncertain) pro forma add-backs to EBITDA for synergies was addressed by the inclusion of a cap. The portability provision and the 10% and 103% redemption feature were removed. The amendments reflected the combined efforts of investors and the deal team to find a middle ground between flexibility and protection—reflecting the broader dynamic currently prevalent in the market.

Caps on EBITDA add-backs have appeared several times in the European high yield market this year, a positive trend that increases transparency, as investors can more easily estimate capacity throughout the covenants. EBITDA is the base metric for calculating the quantum of dividends and debt incurrence available to an issuer, and applicability of the portability exception to a change of control, among other things. Similarly, removal of the 10% at 103% call option is a documentary bellwether suggesting that negotiating leverage has shifted in favor of investors.

Debut issuer Synthomer’s pulled deal in the last week of June showed that even sensible covenants are not enough to take a deal across the line. The current market is less friendly to intensely price-sensitive, opportunistic issuers, and companies that wish to refinance will likely be advised to come sooner than later.

BWAY fared better, with its €475 million of senior secured notes due 2023 pricing in line with talk.

Radisson Hospitality priced its notes at 7% with OID on the last Friday of the month with a fairly conservative set of covenants, inking the deal without amending provisions. As we explained in our report on the preliminary terms for the notes, the covenants will allow HNA group to cause any of its portfolio companies to acquire the issuer without triggering a Change of Control put right for investors. Later on Friday, Bloomberg reported that HNA is exploring a sale of Radisson. The bonds contain a portability exception, though if HNA agrees to sell Radisson to an “Affiliate,” it could avoid the Change of Control put even if leverage is above the portability ratio.

Investors have always been diligent in the analysis underpinning their investment decisions, and now that work is paying dividends through stronger protections and greater transparency. It’s been a long time coming, and we are proud to support these trends and their contribution to the European high yield market’s continued growth and increasing resilience.

If you are interested in accessing the research described above, or if you would like to register your interest in attending our seminar in October, please contact me at [email protected].