European High Yield Year-End 2018 Wrap-Up: Incumbent Flexibility Benefits Issuers and Investors Resist Covenant Erosion as 2019 Volatility Looms

The strength of covenant protections was a central focus in the European high yield market from January this year as investors increasingly engaged with deal teams on documentary terms. These efforts paid off, with a high number of deals pricing with improved protections during the first half of the year.

The second half told a different tale, however, with jumbo LBOs introducing new levels of covenant erosion and issuers utilizing incumbent flexibility to the detriment of investors, causing some bonds to fall in the secondary market.  In the last month of the year, conditions foretold a high potential for market volatility in 2019 that could bring more unforgiving financing conditions for borrowers and tighter underwriting standards.

Potential market volatility next year could herald a shift in negotiating dynamics to investors.  This could mean that 2018’s trend of covenant amendments on the road continues, or that deals are launched with less flexibility than was attempted – and in some cases, achieved – this year.

In this year-end 2018 wrap-up, we review how the year unfolded, highlighting key themes that we believe are most likely to shape the European high yield market landscape for 2019.

January: 2018 Kicks Off a Battle of Wills Over Covenant Protections

High yield issuers came into 2018 all guns blazing – as we warned in a Market Alert, Selecta’s bonds contained all of our “Dirty Half-Dozen” covenant terms, and the “no default” requirement for accessing Restricted Payments capacity under the builder basket was under omitted in four deals launched in a single week.  Our Market Alerts on these issues that month would be the first of nearly twenty this year, highlighting the frequency of attempts by borrowers at eroding key covenant protections.

Selecta priced with several key improvements, including the reinstatement of the default blocker to accessing Restricted Payments capacity, and removal of a provision in the Restricted Payments covenant that would make it easier for the issuer to misuse Unrestricted Subsidiaries.  Indeed, the latter provision was removed from every deal marketed with the flexibility this year as investors honed in on the risk of significant value loss in the wake of J. Crew.

February: Investors’ Covenant Diligence Continues

In February, investors on both sides of the Atlantic worked to improve covenant terms in Algeco Scotsman’s bond offering.  We noted in our preliminary terms report that the covenants were unjustifiably aggressive in the context of the issuer’s very recently checkered past, which involved, among other things, a ratings downgrade and dispute with bondholders.  The pushback paid off and the covenants were amended, significantly improving investor protections, which we described in a special report, “Global Pushback Drives Covenant Overhaul.”

March: Issuers Push Covenant Envelope With Asset Sale Dividends

March marked the beginning of attempts by issuers to build Restricted Payments capacity through asset dispositions.  Stark Group’s bonds included a provision, which we described in a Market Alert, which would have allowed the issuer to make Restricted Payments from “Retained Declined Proceeds.”  The provision would allow an issuer to build capacity from asset sale proceeds declined by bondholders in an asset sale offer.  The term was removed from the final terms of that deal, but it wouldn’t be the last time an issuer would market terms containing similar – and even broader – flexibility.

April: Asset Sale Dividend Flexibility Axed, But Flora Food Group Issuance Heralds New Chapter of Covenant Erosion and BB+ Issuer Freedoms Feature

In April, we warned investors in a special report of significantly expanded freedoms for BB+ issuers demonstrated by Samsonite’s bond offering.  The trend continued through the year, with an increasing number of issuers achieving similar flexibility – a theme to watch in 2019 as some of these issuers come down the rating scale. 

In another special report from April, we highlighted the appearance in Nexi’s bond offering of another provision that would have allowed the issuer to convert asset sale proceeds into Restricted Payments capacity though a “Specified Asset Sale” concept that had just been removed from Fedrigoni’s deal the prior week.

Nexi’s covenants included several other aggressive flexibilities, which investors vigorously resisted. As a result of these efforts, the deal was printed without the “Specified Asset Sale” term, among other improvements.

On the other hand, one issuer managed to pull off an LBO financing that bucked the trend of covenant tightening on the road.  Flora Food Group’s long-awaited bond-and-loan package cleared a highly aggressive covenant package without any amendments, resisting the fate of other issuers in the early part of the year and setting the stage for further deals with far-reaching covenants in similar transactions later in the year.

May: Market Conditions Sour, Results Reveal Incumbent Covenant Capacity

May was difficult for issuers, with three deals pulled due to market conditions.  Results season activity in the month highlighted the dangers of incumbent covenant flexibility, with Shop Direct declaring an unexpected dividend, sending the bonds tumbling in the secondary.  The issuer would not be the last to make use of such capacity to the chagrin of investors, highlighting the importance of close scrutiny of covenant flexibility.

June: Issuers Amend Terms, Pull Deals

June brought more pulled deals, with Salt and Synthomer cancelling transactions.  Another bond-and-loan financing came to market with TDC’s LBO transaction, pricing with amended terms for both instruments.  Cirsa’s all-bond LBO package also had multiple revisions, while InterXion’s bond offering reportedly priced with a 75 bps premium for the issuer to maintain its bespoke covenant flexibility.  The month saw deal teams working closely with investors to find the terms, and price, that would get their deals across the line.

July: Covenants Launched Tighter, Disclosure in Focus

By July covenant dynamics seemed to stabilize, with new issues reflecting a more circumspect approach to provisions.  Techem became one of the first bond and loan financings to price with improved terms to the bond following syndication of the loan piece, reflecting an important win for investors.

Altice France’s refinancing transaction highlighted the importance of disclosure on material levels of covenant capacity. The deal introduced key flexibility to facilitate the upstreaming of proceeds to repay holdco debt, but the disclosure failed to highlight existing capacity despite the backdated builder basket capacity to 2014.  To date, bondholders are still scratching their heads on just how much flexibility Altice might have to repay holdco debt, justifying the investors’ current focus on improving disclosure.

August: Sleepy Summer Slowdown, Results Pay Dividends

August was quiet for primary following the sale of BMC Software’s bond-and-loan financing package, which printed with improved covenant terms for the bond piece.  Results season saw more issuers utilizing built-up dividend capacity to benefit owners, including serial-declarer of dividends Verisure and the just-recently-sold CBR Fashion.  Meanwhile the market looked ahead to an autumn primary market set to be stocked with LBO issuance supply that could be a litmus test for the state of covenant erosion.

September: Jumbo LBOs Bring Covenant Woes, M&A Announcements Set the Stage For Portability

The reality in September was a much rosier picture for issuers than expected resulting in part from a seemingly insatiable appetite from CLOs that put significant pressure on the bond market, in combination with the drastically increasing covenant-lite state of the loan market this year.  Issuers, including Refinitiv and AkzoNobel, were able to push the envelope on covenant flexibility due in part to the cross-border, bond-and-loan nature of those deals that facilitated chopping and changing by deal teams to ink the most favorable pricing and terms for these borrowers.

Refinitiv’s terms cleared with novel flexibility to access gargantuan levels of dividend capacity even when an issuer cannot meet a basic test of financial health, and AkzoNobel’s covenants introduced the most complex set of provisions converting asset sale proceeds to dividends that we at Covenant Review had ever seen.

Looking back, however, it seems that these deals likely reflect the peak of covenant erosion during this economic cycle for the European high yield market.

September also saw M&A announcements for Cognita and United Group, two issuers whose portability covenants could not have been more different, which would serve as a test for how these provisions can play out in practice.  Cognita’s test was based on a gross debt ratio, reducing the ability of new owners to inject new equity in order to trigger the exception to an obligation to make a Change of Control put offer to bondholders.  United Group’s provision, on the other hand, contained vast flexibility for the issuer to choose when and how to calculate the net leverage ratio for purposes of utilizing the clause, creating far more uncertainty about whether it could be used.  Each issuer had a unique fate, which played out dramatically later in the year.

October: Pulled Deals and Portability

October began with a muted primary, but things picked up later in the month with a handful of M&A transactions and refinancing deals.  Another deal was pulled, citing market conditions, while at the end of the month yet another deal was languishing that would ultimately be pulled early in November.

Flexibility hidden in the fine print for distressed issuers came into focus, and portability again took center stage with HEMA and Wagamama both announcing that the provision would be used in connection with the sale of those companies.

HEMA became an ideal case study in why net debt tests for portability provisions can present unique risks for investors, as it was reported that the new owner injected €40 million in equity (which allowed it to exercise portability).  While ordinarily this would be a positive for the transaction, the presence of a Restricted Payments general basket in an identical amount means that what would otherwise be an equity cushion could instead become round tripped cash.

November: A Tale of Two Halves as Market Conditions Decline

November’s market conditions declined from a peak that allowed Verisure to price one of the tightest single-B credits ever whilst also tapping its existing bonds for a dividend recap, to a trough that left investors poring over documentation while the market suffered from idiosyncratic credit risk.

IDG, the high-end interiors company formed by Carlyle and Investindustrial, found a sweet spot in the month, pricing an aggressively drafted deal in line with talk (albeit as the highest priced single-B ever) with just a handful of covenant amendments.

Cognita and United Group each played out their portability stories in November, highlighting unique implications of these clauses for high yield investors.  Cognita, which was unable to utilize its portability exception, took out its existing bonds as part of an LBO financing launched as a TLB together with a subordinated notes tranche.  The high yield piece was ultimately pulled due to investor concerns about the high leverage of the transaction and subordinated nature of the deal, in addition to aggressively drafted documentation.  In its place, the new owners injected additional equity and the TLB was upsized.

United Group’s story was no less dramatic. In a tremendous effort demonstrating investors’ commitment to collaboration and engagement, United Group’s bondholders formed a blocking group to engage with the issuer and its owners following launch of a woefully cheap consent solicitation.  Under the proposed amendments, and for just 10 bps, BC Partners would have been given another bite at the portability apple down the line after the sale of the company by KKR, and with the step-down deleted, no deleveraging would have been required.

Instead, because of investors’ efforts, the consent fee was increased to 25 bps (broadly in line with the market for consents that waive a Change of Control put offer requirement), and BC Partners dropped the request for an amendment to preserve portability.

The transaction underscored a key theme of the year – investors achieve stronger protections and greater returns when they’re able to work together to achieve common aims, and a market that facilitates this ability functions better, and can be more resilient.

December: Primary on Pause as Investors Pore Over Documentary Terms

The final month of the year had many investors using downtime in primary to get back up to speed on documentary flexibility in their portfolios, following on STADA’s high profile debt financing of its MTO, and several transactions announced by issuers that would implicate covenant terms.  Increasing market volatility into the end of the month dampened holiday cheer for some, though it may result in more discipline in underwriting standards and covenant packages in the coming year.

What can we learn from 2018 as we head into 2019’s more volatile landscape?

Looking back at 2018, the European high yield market matured considerably.  Investors and deal teams engaged more frequently, and covenant erosion very likely stabilized. These factors lay important groundwork for 2019, which appears set to bring greater uncertainty to issuers and investors, particularly with Brexit looming. 

This difficult backdrop will make it more important than ever for market participants to create solid foundations upon which to engage, including through better disclosure and greater transparency. Because with a healthy and well-functioning market, we’ll all be better placed to weather the storms that 2019 may bring.