The high-yield indenture is a complex and sometimes highly negotiated agreement. By its nature, it becomes part of a portfolio company's capital structure for a long time, often for as long as a private equity sponsor remains in the investment. Whether it gives the sponsor relief or headaches over that period depends on how successfully the indenture is first negotiated. If for no other reason than that, it merits the full force of the private equity sponsor's attention.
High-yield debt is an integral part of the capital structure of many private equity sponsored portfolio companies. Its principal benefit to the sponsor is to provide long-term debt financing to the portfolio company without the financial covenants and many of the other restrictions typically found in traditional credit facilities. Its principal benefit to investors is a high interest rate as well as the possibility of capital appreciation as the credit quality of the portfolio company improves over time.
Because of the mutual benefits to sponsors and investors, high-yield notes have become an important fixture in the array of financing vehicles available to the private equity sponsor when financing the acquisition or recapitalization of a portfolio company. Largely fueled by the private equity sponsor market, the total value of high-yield debt offerings in 2007 was $165 billion (Thomson Financial Securities Data). Given difficult market conditions in 2008, that number declined to a mere $38 billion.
The importance of high-yield debt to the private equity sponsor highlights the importance of a deeper understanding of the instrument itself. High-yield covenants may look much like the restrictions found in any credit agreement, but they are not the same. Credit agreements generally contain a mixture of "maintenance" covenants and "incurrence" covenants. A maintenance covenant requires the credit party to maintain or achieve a certain level of financial performance to avoid default. Thus, a typical credit agreement might require the debtor to maintain a certain level of revenue or a certain ratio of earnings to fixed charges. Incurrence covenants, on the other hand, are only measured when the debtor proposes to undertake some action, such as incurring additional debt or making a restricted payment.
The other critical distinction between a credit agreement and a high-yield indenture is the time horizon of the instrument and flexibility to amend it once issued. A credit agreement usually carries a term of five years or less; an indenture's term is usually seven to ten years. A credit agreement can be, and often is, amended with some regularity; an indenture can only be amended by consent solicitation, which is costly and time consuming. It is this aspect of the high-yield indenture that demands the private equity sponsor's attention.
Fundamentals of High-Yield Covenants
When negotiating the high-yield indenture, the overall philosophy of a high-yield covenant package must be understood. The fundamental goal is to protect the bondholders by prohibiting actions by the issuer and its restricted subsidiaries that may be detrimental to their ability to pay the interest on and finally repay the bonds. Subject to numerous exceptions and qualifications, in a typical high-yield indenture covenant package, the bondholders request the issuer to do the following:
· Not to further leverage the business; the bondholders are investing in the bonds based on the issuer's current and planned borrowings.
· Not to distribute or invest assets outside of the issuer's own business; the bondholders would rather the issuer use these "extra assets" to repay them.
· Not to sell assets unless the issuer uses the proceeds to reinvest in the business, reduce indebtedness or repay the bondholders.
· Not incur any more liens, including using sale-leaseback transactions; the issuer's assets are much more valuable to the bondholders if they remain unencumbered.
· No signing of sweetheart deals with affiliates; these transfer value away from the business and the bondholders get nothing in return.
· Not to allow the issuer's subsidiaries that have not guaranteed the bonds to guarantee the issuer's other debt; the bondholders cannot allow the issuer to subordinate them to such debt by giving the issuer a direct claim on the assets of these subsidiaries.
· Not to allow restrictions to be placed on the issuer's restricted subsidiaries that make it harder to get money upstream to pay the interest to and finally repay the bondholders.
· Not sell stock in the issuer's restricted subsidiaries; the bondholders wish to have the only equity claims against these companies using their position as the issuer's creditors.
It takes many pages to make these simple requests because businesses operate in a complex world and many carefully crafted exceptions to these general rules may be required to allow for this reality. The other factor is that the language matters in high-yield indenture covenants. Given the amount of money generally at stake under a bond indenture, litigation over language is not uncommon. Careful consideration and drafting at the front end can eliminate or at least minimize the risk of future costly and unpredictable litigation.
Negotiating the Indenture: The Parties
Negotiating a high-yield indenture is unlike any other negotiation in a variety of ways. The indenture itself is not negotiated; the negotiations involve the section of the offering memorandum entitled "Description of Notes". This section sets out, verbatim, the relevant covenants of the indenture, with the rest of the indenture consisting of so-called boilerplate. The exact terms of the notes as set out in the indenture are too precise and important to risk summarizing or paraphrasing in the disclosure document.
The more substantive difference in these negotiations is that the roles and incentives of the various parties are less than clear cut. For example, while the sponsor and portfolio company clearly want maximum flexibility, at the same time they want the notes to be marketable; marketability may suffer if the note terms differ materially from investor expectations. The investment banks' primary interest seems to be in keeping the indenture within the range of marketability, but at the same time they are also acting as financial advisors and should be looking out for the sponsor's financial interests. Adding to the complexity is the investment banks' interest in "franchise issues" that is, maintaining their credibility with buy-side players.
Finally, in a situation where the high-yield notes are being issued in connection with the acquisition of a portfolio company, the sponsor and the company are essentially on the same side of the table when negotiating the indenture, but are simultaneously negotiating against each other in the acquisition transaction.
However, the negotiation itself resembles a typical credit negotiation in which investment banks' counsel presents a document that contains some, but not all of the typical carve-outs a sponsor can expect to receive. Issuer's counsel then works with the sponsor and the portfolio company to prepare a mark-up that addresses the company's needs and brings the description of notes up to what, in issuer's counsel's experience, is a "market" deal.
The parties negotiate from a posture that basically has the company and its counsel asking for additional flexibility and the investment banks' and their counsel resisting those requests. Only at the end of the negotiation does each party recognize the subtext of their respective interests, that is, marketability on the part of the sponsor and the company, and their role as financial advisor on the part of the investment bankers; once this takes place, the parties tend to resolve their differences quickly and without unnecessary drama.
Involvement of the private equity professionals and the portfolio company's CFO and financial and accounting staff in this process is essential. Issuer's counsel is rarely able to anticipate all of the specific flexibility the company needs. Even the boilerplate provisions can be important in this regard. Time must also be devoted to thinking about all of the reasonably foreseeable transactions and activities in which the company can engage and testing these under the proposed note terms to see whether they are permissible. A few of the areas that should be examined include:
· Future acquisition, joint venture and investment plans.
· Future financing plans including equipment financing, sale-leaseback transactions and other secured debt arrangements.
· Debt or debt-like arrangements incurred in the ordinary course of business.
· Future operations outside the US.
· Need for letters of credit and other credit enhancements.
· Anticipated funds flow between and among affiliated companies.
· Potential new lines of business.
· Potential related party transactions.
It is also important to harmonize the note terms with the covenants and other provisions applicable to existing company debt instruments such as secured credit facilities, recognizing that they can differ somewhat due to the inherent difference in the instruments. Maintaining flexibility in the credit agreement may be of little use if the same transaction requires consent under the indenture. Indeed, given the difficulty of getting waivers under indentures, failing to get the language right in an indenture can dictate corporate actions for years to come.
The Credit Parties
Before entering into a detailed discussion of the important covenants contained in a high-yield indenture, it is important to understand the structure of the high-yield credit and how various categories of credit parties relate to the indenture and the credit. To understand the high-yield structure, the concept of the "system" must be clear, that is, the issuer and the guarantors (and, for some purposes, non-guarantor restricted subsidiaries), but excluding any unrestricted subsidiaries (see below). The high-yield indenture generally regulates the flow of money outside of the system (including the ability to repay certain debt to parties outside of the system) and allows the free flow of money among parties inside the system. Many professionals liken the high-yield indenture to a plumbing system, which, while an imperfect analogy, helps in understanding the concept of free circulation within the system and the prevention of leaks.
The threshold question in setting up the high-yield credit party structure is determining who should issue the notes. For existing public companies, the issuer is typically the public company itself. For nonpublic companies, the matter is less clear. If the parent company in the corporate chain is also a fully functioning operating company, the parent company is still likely to be the issuer. If the parent company is a pure holding company, the question becomes more complex.
A typical outcome is that the issuer is a second-tier operating/holding company, with all domestic subsidiaries, and possibly the parent, guaranteeing the debt, although the parent guarantee creates some complications under the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). The principal driver behind this structure is the desire on the part of the company's senior lenders to be lower in the capital structure and, therefore, closer to the operating assets, and the note holders' desire to be at the same level as the senior debt.
High-yield notes are often guaranteed by most, if not all, of the company's domestic subsidiaries, and sometimes by the issuer's parent holding company. The guarantee creates a direct obligation on the part of the guarantors. The question of whether to issue a parent guarantee is both a credit decision and a financial reporting decision. The credit enhancement of a parent guarantee when the parent is a pure holding company is less than compelling, but some investment banks may recommend it to enhance their marketing of the notes.
The question of whether to provide a parent guarantee is also influenced by the senior secured banks' desire to get a pledge of the operating company's common stock, which is thought to require some obligation on the pledgor's part to be effective. If the parent does not guarantee the securities, the issuer must provide financial reports that are not consolidated with the parent company but instead are consolidated with all subsidiary guarantors. If the parent does guarantee the notes, the issuer can report consolidated financial statements at the parent company level, simplifying its reporting requirements.
Issuers are also influenced by the requirements of the Sarbanes-Oxley , which are only applicable to the parent if there is a guarantee. Of course, this assumes the parent is not itself a public reporting company subject to Sarbanes-Oxley because of its own publicly traded equity or other public debt. In particular, Sarbanes-Oxley prohibits loans to executive officers, which can adversely impact the company's ability to provide tax-efficient management equity to its executives. For this and other reasons, parent guarantees are becoming less common when the parent is not a public reporting company.
The enforceability of the guarantees may be limited by applicable fraudulent conveyance laws. The purpose of these laws is to protect the other creditors of the guarantor. They generally provide that if a guarantor did not receive adequate value for its guarantee, the guarantee may not be enforceable. While legal practitioners generally believe that the guarantee of indebtedness incurred to finance the consolidated group is supported by the parent's implicit promise to provide intercompany financing when needed, no formal legal opinion on the subject exists. The market has learned to accept that fraudulent conveyance risk is inherent in the guarantee structure.
Non-guarantor Foreign Subsidiaries
Federal tax rules effectively prohibit the guarantee of a domestic company's indebtedness by a foreign subsidiary. Under the rules, to the extent such indebtedness is so guaranteed, the earnings of that subsidiary, whether or not dividended to the parent company, are treated as a "deemed dividend", increasing the company's federal income tax obligations. This result is well understood by high-yield professionals, and the inability of foreign subsidiaries to issue guarantees is not (or at least should not be) controversial.
The term restricted subsidiary is a bit misleading. They are restricted in the sense that they are governed by the terms of the indenture; they are not restricted in the sense that they are freely able to transact with other restricted subsidiaries. They should be thought of as being in the system rather than being restricted. Generally, all subsidiaries of the issuer are restricted subsidiaries unless designated as unrestricted subsidiaries, including both guarantors and non-guarantors. This means that all income produced by these subsidiaries is counted for purposes of compliance with the various covenants described below, and these subsidiaries are all limited in their ability to take the various actions limited by those covenants.
The distinction between guarantors and non-guarantor restricted subsidiaries is more subtle. Some actions, such as making restricted payments, are, to the extent permissible at all, permitted by any restricted subsidiary. Other actions, principally the incurrence of indebtedness, are limited to guarantors when permitted at all. This is to avoid allowing the notes to become structurally subordinated to other indebtedness.
Unrestricted subsidiaries are the mirror image of restricted subsidiaries. These subsidiaries are treated as outside of the system and therefore are not restricted in what they can do, but at the same time, they are not permitted the freedom to freely interact with the credit parties inside the system as are restricted subsidiaries. Thus, the income from unrestricted subsidiaries does not support the consolidated group's compliance with the high-yield covenants, and all transactions with the unrestricted subsidiary must be permitted by the transactions with affiliates covenant, any capital contributions or loans to, or guarantees of the indebtedness of, the unrestricted subsidiary are restricted as investments in the unrestricted subsidiary. Many issuers look to the creation of an unrestricted subsidiary to solve a perceived problem under the indenture only to find that the formation of an unrestricted subsidiary causes more problems than it solves.
The Covenant Package
A high-yield indenture contains both standard covenants and covenants unique to the type of high-yield offering being used in the financing.
The indebtedness covenant and the restricted payments covenant (see below) are the two most important covenants in the high-yield indenture. The indebtedness covenant generally restricts the issuer and any restricted subsidiary from incurring additional debt except in two circumstances:
· If the issuer meets the coverage ratio exception, the issuer and any guarantor are permitted to incur ratio debt.
· The issuer and other credit parties may typically issue permitted debt at any time.
The indebtedness covenant is important because additional indebtedness dilutes the bondholders' claims against the assets and cash flow of the issuer and guarantors. In addition, increased debt service requirements can weaken the credit to the detriment of the value of these bonds.
Indebtedness generally includes all borrowed money, capital leases and most other types of obligations to pay money. It does not, however, typically include ordinary course trade payables or other debts routinely incurred and retired in the ordinary course of business.
The coverage ratio exception allows the issuer and any guarantor to incur unlimited additional indebtedness if, after giving pro forma effect to the additional indebtedness, it meets the defined ratio of EBITDA to fixed charges (the coverage ratio). The defined coverage ratio is most commonly 1.0 to 2.0, but sometimes it is higher or steps up over time to higher ratios in subsequent years. Issuers typically are not eligible for the coverage ratio exception at the time they issue the notes and thus must look for another exception to incur debt in the immediate post-issuance period. This is because the investors in the bonds do not want additional debt issued unless and until the issuer's ability to take on and service more debt is meaningfully enhanced by growth in profitability and cash flow.
The typical indenture also allows for various types of permitted debt. This is debt that the issuer may incur regardless of its recent performance or financial condition. Permitted debt generally falls into two categories:
· Technical debt not otherwise intended by the indenture to be prohibited.
· Limited debt baskets permitted in pre-defined dollar amounts.
There are many items that are technically indebtedness, but that no one believes should be prohibited by the indenture. These include transactions such as the inadvertent writing of a bad check (technically creating debt to the bank that cashes it). There are also many types of indebtedness that everyone agrees are debt, but that the company should be able to incur, such as guarantees of indebtedness otherwise permitted by the indenture to be incurred. The initial draft of the description of notes may contain a few such exceptions; experienced company counsel may negotiate for many more.
Some indentures categorize some of these carve-outs as permitted indebtedness, while others carve the item out of the definition of indebtedness altogether. The high-yield indenture requires a careful and informed reading to fully understand its nuances on this point. Permitted debt may also include several specified dollar baskets, including possibly a basket for local currency debt issued by foreign subsidiaries (for working capital purposes) and, most importantly, a basket for debt issued under the company's senior credit facilities. Indentures may also contain a "hell or high water" basket, which permits a limited dollar amount of debt to be incurred for any reason or no reason at all. Issuers should guard this basket carefully, as hell and high water both occur more often than not.
A noteworthy issue is whether the various baskets are refillable or one-time only. The issuer would obviously prefer to be able to refill the baskets as indebtedness incurred under the basket is repaid. In years past, one-time only baskets were common. In recent years, there has been a movement toward more refillable baskets.
Indebtedness at subsidiaries is often called out for even more restrictive treatment. This is because debt at a lower-tier company becomes structurally senior to the high-yield debt incurred by the higher-tiered issuer. In other words, the high-yield debt becomes structurally subordinated to the debt at this subsidiary level. The only claim the high-yield debt issuer has to the assets of one of its subsidiaries is a claim as the equity holder of the subsidiary. This equity claim is subordinated to the debt claim of the holders of indebtedness issued by the subsidiary, but can be improved by requiring any financial support from the parent to be made in the form of intercompany loans rather than equity contribution. This can also affect the company's tax position and should be analyzed carefully. Structural subordination is the reason for, and its effects are intended to be reduced by, the subsidiary guarantees.
Restricted Payment Covenant
The restricted payments covenant is the other key covenant in the high-yield indenture. This covenant restricts the flow of money outside of the system, preserving the company's ability to repay its indebtedness. Payments restricted by this covenant include:
· Dividends to stockholders.
· Investments made in third parties.
· Loans made to third parties.
· Guarantees of indebtedness of third parties.
It is also important to note what is not limited by this covenant including:
· Acquisitions of companies that become restricted subsidiaries.
· Capital expenditures.
· Intercompany loans and guarantees.
Like the indebtedness covenant, the restricted payments covenant permits two types of restricted payments:
· Payments made under a growing net income basket for restricted payments.
· Identified categories of permitted restricted payments.
The net income basket generally permits restricted payments to be made in an aggregate amount up to 50% of the company's consolidated net income (less 100% of any loss) in the period (taken as one accounting period) from the time of issuance until the time of the restricted payment. There are several nuances to how this amount is calculated, not the least of which is that the consolidated net income can exclude the profit or loss of any unrestricted subsidiary. Thus, if an issuer wants to make restricted payments (what issuer is not?), the designation of a profitable subsidiary as unrestricted must not be taken lightly. Permitted restricted payments again fall into two categories:
· Restricted payments that should be permitted at any time, like the acquisition of an entity that becomes a restricted subsidiary or the payment of a dividend that was permitted to be paid when declared by the board.
· A series of predefined baskets.
For an issuer either owned by a non-guarantor holding company or has an obligation to make management fee payments to its private equity sponsor, a carve-out must be negotiated for money to be dividended up to the parent to pay its expenses, for example, franchise taxes and other expenses, or to pay the management fee. The baskets are divided into two sets:
· Permitted restricted payments per se.
· Permitted investments.
There are often separate hell or high water type baskets for each of these. It is important to remember that investments are restricted payments, and thus the issuer can aggregate the two baskets when attempting to make an investment too large to be permitted under one or the other.
In the case of joint ventures, most high-yield indentures allow limited flexibility for them. Forming and operating a joint venture tends to create difficult interpretive questions under the indenture. This is because bondholders do not want cash removed from the issuer's balance sheet and invested in an entity not controlled by the issuer and subject to the covenants of the indenture. Issuers for whom joint ventures are a serious option must provide for necessary flexibility in drafting the high-yield covenants and, after the fact, parse the indenture carefully when attempting to form a joint venture.
Dividend Stoppers Covenant
The dividend stoppers covenant is among the more difficult covenants to comprehend in a typical high-yield indenture. It is designed to ensure that the cash generated by restricted subsidiaries can flow up to the issuer for payment of the notes, unhindered by limitations other than those imposed by law or other routine limitations. Because a parent company's claim on its subsidiaries' assets and cash flow is typically only that of an equity holder, the only way for a subsidiary to get cash upstream to its parent is by paying a dividend.
Therefore, the dividend stoppers covenant attempts to ensure that there are no limits on a subsidiary's ability to declare and pay dividends. This is not usually a practical problem for an issuer, with one important exception; the joint venture. It is typical in a joint venture arrangement for the joint venture partner (even a minority partner) to have some measure of control over the joint venture's ability to pay dividends. This would not be permitted by most dividend stopper covenants, and has itself been the breaking point of many proposed joint ventures. The typical structural response to this issue is to form a joint venture as 50% or less owned by the parent, making it a non-subsidiary and therefore not subject to this covenant. Of course, this also has the effect of causing any investment in that subsidiary to be a restricted payment under the indenture.
Limitations On Liens Covenant
The limitation on liens covenant is almost identical, both in form and intent, to the similar covenant contained in all credit agreements. This covenant generally restricts the company's ability to grant liens (other than permitted liens) on its assets unless the company grants an equal and ratable lien to the holders of notes.
The challenge in the high-yield context is to cause the definition of permitted liens to match up as exactly as possible to the same definition in the company's credit agreement. Depending on the views of the investment banks' counsel on this subject, this can be as easy as incorporating that definition by reference or cutting and pasting that definition verbatim, or can be as hard as negotiating each lien item word for word. In either event, the business deal should be that there can be no lien which would be permitted by the credit agreement which would not be permitted by the indenture, and that there may be some permitted by the indenture which would not be permitted by the credit agreement.
Assets Sales Covenant
Also known as the limitations on asset sale covenant, the use of the word "limitations" is actually quite misleading. While used to discourage the sale of assets, the covenant typically serves to merely define the acceptable use of the proceeds from asset sales. Generally the proceeds must be used to permanently repay debt (not necessarily the debt issued under the indenture) or to buy "replacement assets". The term replacement assets is almost equally misleading, as these assets are not limited to equal replacement of assets , but rather, generally include any assets that are to be used in the company's business.
This covenant also typically provides that assets can be sold only for consideration consisting primarily of cash (75% to 85%). Asset swaps, however, can be specifically negotiated for as an acceptable alternative to a cash sale if there is a realistic possibility that these transactions may occur. In any event, this covenant requires that assets be sold for their fair market value. To the extent the proceeds of asset sales are not used in accordance with the covenant, the issuer must use the proceeds to make a tender offer to buy the outstanding notes at a price equal to their face value plus any accrued interest. It is common to negotiate for some basket amount of proceeds that does not have to be reinvested, but this is usually a relatively small amount. Because the company can usually find a use for the cash permitted by the covenant that is more productive than offering to repurchase the notes, such an offer is rarely made.
Transactions With Affiliates Covenant
The transactions with affiliates covenant, like the asset sales covenant, does not actually prohibit transactions with affiliates, but it does impose conditions on the completion of such transactions. The conditions to complete a transaction with an affiliate of the company are typically as follows:
The transaction must be on an arms'-length basis.
The following approvals must be received:
· below a certain dollar threshold (usually $5 to $15 million), no approvals required;
· above a certain dollar threshold (usually $25 to $50 million), board approval and a fairness opinion from a financial advisor; and
· between the two ranges above, board approval.
Board approval in these instances is often defined to mean the approval of a majority of the directors that do not have an interest in the transaction.
The indenture may also contain several other covenants including:
· Equity clawback.
· No call periods and optional redemptions.
· Limitations on sale-leasebacks.
· Maintenance of existence.
· Delivery of compliance certificates.
While these covenants are important and are subject to some negotiation, they do not typically occupy the same amount of attention as the covenants discussed in detail above.
Copyright © 2009 Legal & Commercial Publishing Limited and Practical Law Company, Inc. All Rights Reserved. Reprinted with permission.