Shifting Market Dynamics Bring Covenants Into Focus: European High Yield March Wrap-Up by Covenant Review

As the first quarter of 2018 drew to a close, market dynamics showed signs of shifting from the issuer-friendly backdrop of 2017 towards a more balanced middle ground. Yields widened and investors carefully scrutinized covenants, forcing documentary concessions from several issuers this month. Even BB+ credits came under investors’ watchful eye. Not all covenants got tighter, however, as seasoned issuers gained new sources of covenant flexibility compared to prior deals by way of opportunistic refinancings. The overarching lesson to take away from this complex backdrop is that when it comes to crafting a covenant package, context is everything. March proved that flexibility based on precedent alone is a thing of the past.

The marketing process for Stark Group’s offering of €515 million of fixed and floating rate senior secured notes due 2024 is a useful case in point, as it demonstrated the unwillingness of investors to accept a precedent-based argument for covenant flexibility. In a Market Alert published a few hours after the deal was launched, we warned investors about a provision that would give the issuer unreasonable flexibility to convert certain asset sale proceeds into dividend capacity.

As we noted in our Market Alert, the concept was not entirely unprecedented. What was concerning, however, was the nature of the flexibility in the context of the issuer’s business. In addition, accessing capacity generated under the basket would be easier for Stark Group than it would be for other issuers provided with this flexibility, as there were no protective conditions or caps in place. Given this context, we argued that regardless of whether the provision had appeared in prior deals, it was not appropriate flexibility to extend to this business. Investors agreed, and the provision was removed from the final terms for the deal. 

Our full report on the preliminary terms for the deal highlighted other significant risks, including a provision that would explicitly permit Unrestricted Subsidiaries to use value transferred from the restricted group to take shareholder friendly actions, even if the covenants wouldn’t allow the restricted group to do so directly. J. Crew’s storied trapdoor put the market on watch for such covenant-engineered flexibility. Again, while the provision had appeared in a handful of other deals this year, our concern was the ease with which this company could take advantage of the provision to the detriment of bondholders. Moreover, investors had rejected the off-market flexibility in at least one deal this year. Given this context, investors refused the precedent justification for the provision and it was removed. 

The amendments made to the Stark covenants, which we analyzed in a follow-up report, directly addressed the risks we had raised in our Market Alert. Despite the presence of documentary precedents in the market, the investors in Stark Group’s bonds negotiated contextually, and successfully. The process set a benchmark for what productive discussions about covenant terms between deal parties can achieve. 

Another issuer that improved covenant protections in response to investor feedback was Italian software company TeamSystem, which came to market with a €750 million floating rate bond package to refinance existing debt. We noted several critical flaws in our report on the preliminary terms, including the problematic formulation of TeamSystem’s incurrence ratios calculations.  Investors insisted on the insertion of a cap on certain future EBITDA add-backs and the curtailment of the scope for the company to net cash from leverage ratio calculations, addressing the risks arising in the context of the financials of this particular issuer.

Even a high credit rating wasn’t sufficient justification for particularly problematic covenant flexibility, as BB+ rated Corestate was required to amend the preliminary covenant terms for its €300 million of notes due 2023. We published a report describing the blended investment grade / high yield covenant package, colloquially referred to as a “chimera.” These hybrid beasts have been appearing with greater frequency of late, as nearly-investment-grade issuers attempt to shed fulsome junk bond restrictions in favor of a more lithe set of covenants. Investors managed to get comfortable with the vast majority of the flexibility requested by Corestate, but insisted that the company curtail certain excessive Restricted Payments capacity we described in our report, and bolster downside protection through enhanced Change of Control provisions. 

Investors were willing to accept some increased covenant flexibility, however, allowing seasoned issuers to loosen protections compared to prior deals. Arrow Global achieved greater flexibility in its Debt, Liens, and Restricted Payments covenants through an opportunistic make-whole refinancing of its outstanding 2023 maturity FRNs with new FRNs due 2026.

Paprec’s offering of €800 million of senior secured fixed and floating rate notes due 2025 also served as a vehicle for the issuer to gain additional covenant flexibility. We explained in our report on the preliminary terms for the deal that, in contrast to its prior bonds, the covenants would permit the issuer more flexibility in calculating ratios for secured Debt capacity and making Restricted Payments. For example, a new pro forma trick will allow Paprec to ignore certain debt when it calculates its leverage ratio. Because that ratio is used to determine capacity under the leverage ratio-based Restricted Payments carveout, inclusion of the pro forma trick essentially facilitates debt-financed dividends.

We view this pro forma trick as one of the most nonsensical provisions to have infected the European high yield market during the latest issuer-friendly, precedent-driven period in the credit cycle. It is at the top of our hit list of unreasonable flexibilities that need to be axed. 

Progroup demonstrated that issuers gaining flexibility will eventually seek to take advantage of it. The covenants for the issuer’s existing €150 million of senior secured FRNs due 2024 issued last year included additional flexibility for it to refinance its outstanding holdco PIK notes, which it utilized this month. We noted in a Market Alert published in connection with last year’s deal that while the covenants were being marketed by the syndicate as “similar” to the issuer’s prior deal, in reality the issuer had incorporated new uncapped capacity in the Restricted Payments covenant that would allow proceeds from a future debt offering to fully repay its holdco PIK notes. Without that provision, Progroup would have had to use other sources of Restricted Payments capacity or request consent from bondholders to take out the holdco PIK notes. 

In another refinancing transaction, Softbank launched an exchange offer and consent solicitation to refinance bonds issued in 2015. In exchange for 100 bps, bondholders were asked to relinquish certain protections against structural subordination, allow for more scope for value loss through Restricted Payments, and reduce the downside protection afforded by the Change of Control provisions, amongst other things. The new terms would also facilitate a potential listing of Softbank Corp., resulting in the potential loss of credit support. We urged investors to consider whether the consent fee was sufficient to compensate bondholders for these increased risks. 

KCA Deutag also launched a consent solicitation to facilitate financing for its acquisition of certain assets of Dalma Energy. Noteholders were asked for their consent to dilution of their existing collateral by providing the issuer with an additional $425 million in secured debt capacity to execute the acquisition. The five-day time period for consenting was in line with other consent solicitations that have come to market over the last few months, but seemed unreasonably short in the context of what investors were being asked to consider. Could five days be considered sufficient time for bondholders to analyze the nature of the assets being acquired, whether the transaction would be value accretive to an extent sufficient to justify the dilution of their existing collateral, and whether the 25 bps consent fee was sufficient to compensate them for the flexibility provided to the issuer? We wrote a report describing what the capital structure would look like before and after the proposed amendments came into effect to assist investors in their analysis.

Concurrently with the consent solicitation, KCA Deutag came to market with an offering of senior secured notes due 2023. These 2023s have materially expanded the covenant flexibility compared with the most recently issued 2022s, which refinanced the issuer’s near-term maturity 2018s last year. We had noted in our report on the 2022s that the provisions in that bond would give the issuer far more Debt, Liens, and Restricted Payments capacity compared to 2018s being refinanced. Even though the issuer wasn’t asking for increased capacity compared to its other outstanding bonds due 2021, investors were unwilling to allow this additional capacity, and the issuer was forced to bring the covenants in line with the more restrictive provisions in the 2018s.

The dynamics for the marketing process for the 2023s was notably different, proving that in the current market, context is everything. Instead of a nearly distressed refinancing, the issuer was selling an acquisition story to justify the same increased covenant capacity it had requested for the 2022s. In our report on the preliminary terms for the 2023s, we urged investors to insist that certain flexibility be curtailed, or that the coupon appropriately reflect the additional risk posed by broader capacity compared with the 2022s. The bonds priced without covenant concessions, but with a 9.625% coupon. The 2021s, which contain similar flexibility, carry a 7.25% handle. Though there are too many moving parts to know for sure, it is possible that in this case the issuer did have to pay for the increased covenant flexibility.

The holders of the 2022s can rest assured that their more protective covenant package puts them in a favorable position in the capital structure. If KCA Deutag wishes to access the increased capacity present in the 2021s and the 2023s, it will need to pay holders of the 2022s for their consent. For investors in those notes, the refusal to accept looser covenants may well make them money down the line.

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