As mergers and acquisitions return with vigour to Europe, so-called “portability” features in high yield bonds have become commonplace.2 High yield bonds have traditionally required the surviving entity in a merger to offer to purchase all outstanding notes at 101% of face value after a change of control. Portability features provide ways to nullify this requirement—for example, by requiring a change of control offer only if a post-merger leverage test fails, or if the merger results in a credit ratings downgrade. Portability makes a company more attractive to potential buyers because they won’t need to refinance the company’s existing bonds.
But what about the scenario where the acquiring company wants to remove the target company’s high yield bonds upon consummation of a merger?
Whether motivated to remove the burden of restrictive covenants, to refinance with lower-priced debt or to deleverage generally, an acquiror who wants to be rid of a target company’s high yield bonds cannot count on using a change of control offer to take them out, because a change of control offer is just that: a mere offer. Bond holders may choose to ignore an offer to purchase at 101% (especially in today’s healthy bond markets, where the majority of European high yield bonds are trading above par). Even with bonds that are trading below par, there is always a chance that some holders will choose to stay in the issue. So long as any high yield bonds remain outstanding, the issuer will be bound by those bonds’ restrictive covenants.
The only sure way to remove an entire series of bonds from a capital structure before maturity is to redeem them at a premium price according to their terms. European fixed rate high yield bonds will usually have an optional redemption available at the approximate mid-point of their tenor at a standard formulation of par plus half the coupon. By way of example, that would mean that 10% eight-year notes could be called at 105% at their fourth anniversary. Things get more complicated—and notably more expensive—during the period prior to the first optional redemption date. During the period prior to the first optional redemption date, most high yield bonds allow a redemption with a “make-whole” payment comprised of the net present value of all scheduled payments from the date the bonds are redeemed to the first optional redemption date plus the future optional redemption price. To use our 10% eight-year note example, a redemption of those notes after only one year outstanding would require paying the net present value of three years’ worth of interest payments plus 105% of face value—a total premium in excess of 30%. In the face of such complexity and expense, a CFO might say “there’s too much confusion, I can’t get no relief!”3
In such an expensive scenario, where redemption is desirable but too dear, the solution may be to engineer a tender offer and consent solicitation in which bondholders are offered a price somewhere between the current market price of the notes and the too-expensive make-whole price. A tender offer alone is simply a means to purchase bonds from willing holders. The consent solicitation is where the added relief for the company comes in. If a majority of holders consent to a change in the indenture (trust deed) governing the notes, it is possible to remove the bulk of the restrictive covenants from the notes, leaving behind not much more than the sacred “money terms” (timely payment of interest and principal). Once the requisite majority of bondholders tender their notes along with their consent to change the indenture, the other bondholders, faced with the prospect of holding notes without teeth, are more likely to fall in line for the redemption price. Using (very) rough figures, if the notes in question are trading at 108% and make-whole redemption would cost 120%, perhaps an offer at 110% could attract a majority of holders to modify the indenture.
Tender offers in conjunction with consent solicitations are very common liability management techniques in the high yield arena, but they do carry legal and reputational risks. In addition to the general market and game theory-type advice needed from finance professionals with regard to optimally pricing a tender offer and consent solicitation, counsel need to analyse the structure and context of such a proposal to ensure that no legal conflicts arise with other contracts, relevant securities laws are complied with and that governing case law does not raise potential difficulties.
2013 was a record year for European high yield issuances, including an influx of first-time issuers, lower-rated issuers and a return of “bull market” instruments. One type of high yield bond that had a bull market resurgence in 2013, the PIK-toggle note, has received cautionary attention in the financial press.4 Although PIK-toggle notes are a type of debt instrument that only bloom during sunnier seasons in the high yield market, the past year’s crop includes a new structural twist, often called pay-if-you-can, that arguably makes PIK-toggles more predictable and market-friendly.
“PIK” stands for “Pay-In-Kind” and is used as a shorthand phrase for any debt instrument in which interest payments are capitalized—increasing the total principal amount at each interest payment instead of paying interest in cash.
The original forms of high yield PIK notes were simply non-cash-pay bonds, usually issued at a holding company as a way of adding additional gearing to an acquisition finance capital structure. In the mid-2000’s, high yield notes were issued in which the obligor could at its option pay interest in kind or in cash—the “toggle” feature of a PIK-toggle note. With the advent of the global financial crisis, some market participants felt that the age of such exotic instruments had passed.
The European high yield market of 2013 showed that PIK-toggle notes had merely been in hibernation, with at least 14 new issuances during the year. The market’s acceptance of PIK-toggle notes is surely a sign of an issuers’ market, but the bond investors’ decisions were made easier by the introduction of the pay-if-you-can approach. With a pay-if-you- can structure, the PIK-toggle obligor must pay cash interest to the extent that it has the available liquidity to do so.
The exact formulas for determining available cash payment amounts differ from deal to deal, but are generally based upon the calculated amount of cash that could be distributed upwards from the issuer’s subsidiaries taking into account all obligations at those subsidiaries. For example, if a holding company issued PIK-toggle notes and the operating company below it issued standard cash-pay high yield notes, the available cash for the holding company would be calculated with respect to the dividend restrictions in the operating company’s high yield notes (i.e., the operating company’s Limitation on Restricted Payments covenant). One of the key variations from bond-to-bond in the PIK-toggle space is the type and amount of any cash cushion that is to remain at the operating subsidiaries of the PIK-toggle issuer, but the general theme of pay-if-you-can broadly applies. The PIK-toggle issuer may only opt to pay non- cash interest if the available amount would cover less than 100% of the interest payment due. Even then, the amount of non-cash interest that may be paid will usually be limited on a sliding scale (for example, if available cash equals more than 75 per cent, but less than 100 per cent. of the interest payable, only 25% of the interest payment may be PIK’d).
Pay-if-you-can has helped bring PIK-toggle notes back into the European market. Time will tell if the change in approach has made very highly leveraged structures more resilient when money gets tight.