Recent progress has been made in reducing the refinancing wall, but changing bank regulatory requirements will likely inhibit the availability of bank debt, particularly for speculative-grade borrowers, while the demand for debt capital to fund refinancing activity and business development remains significant. This client alert briefly evaluates the current state of the refinancing wall; outlines the potential vulnerability of speculative-grade borrowers to reduced bank lending; and provides an overview of the negotiation and function of high yield covenants, with a particular focus on issues of practical importance for financial and other non-legal managers of speculative-grade borrowers that may be considering alternatives to bank financing.
The Current State of the Refinancing Wall
The debt “refinancing wall” has been a frequent topic of commentary in recent years. As market observers know, the term generally refers to outstanding bank debt and bonds maturing between 2012 and 2016, with the largest amounts due from 2012 to 2014. The refinancing wall is, of course, the result of the significant amount of debt incurred leading up to the 2008 credit crisis with typical maturities of six to seven years (an average of $212 billion per year from 1997 to 2005 peaking with $1.1 trillion of combined new debt in 2006 and 2007) followed by minimal refinancing activity in 2008 and 2009. 1 According to Standard & Poor’s (S&P), excluding securitized loans, the bank loan and debt capital markets will need to fund an estimated $43 trillion to $46 trillion of debt refinancing and new corporate borrowings between 2012 and 2016 in the United States, Europe, China and Japan. During this period, S&P estimates $11.1 trillion to $11.7 trillion of debt needs in the US and $10.5 trillion to $10.9 trillion in Europe, in each case including approximately $8.6 trillion to refinance existing debt and the balance for projected new borrowing.2
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Of course, included within the upcoming maturities is a significant portion of speculative-grade debt (rated BB+ or lower by S&P; Ba1 or lower by Moody’s). Excluding financial institutions, 23 percent of debt rated by S&P and maturing between 2012 and 2016 in Europe is speculative-grade. 3 The percentage of S&P-rated debt maturing in the same period in the US that is speculative-grade is significantly higher at 59 percent for nonfinancial borrowers.4
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In addition, both European and US borrowers rely heavily on bank debt, which as of May 2012 comprised 85 percent and 53 percent, respectively, of the total indebtedness of European and US non-financial borrowers.5 With speculative-grade borrowers accounting for a significant percentage of all outstanding bank and capital markets debt in the US and Europe (59 percent and 23 percent, respectively, as noted above), any reduction in bank lending to speculative-grade borrowers will have a significant impact on their ability to refinance existing debt or incur new debt to fund business development.
Changing Bank Regulation and the Vulnerability of Speculative-Grade Borrowers
Against the backdrop of borrowers’ continuing need for debt capital, banks in the US and Europe are confronting an evolving regulatory environment and continuing economic challenges. In Europe, banks face an economic recession, the continuing euro crisis and the existing leverage on their balance sheets. In this difficult environment, European banks face pressure to quickly meet the Basel Committee on Banking Supervision’s proposed capital, funding and liquidity requirements (Basel III). In the US, amidst a tepid economic recovery, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) certainly indicates the increased probability of higher capital standards or liquidity and reserve requirements, though no specific standards have yet been set. Bank credit availability can reasonably be expected to decline as banks adjust their loan portfolios either to satisfy increased capital and reserve requirements already implemented or in anticipation of new capital and reserve regulations. Any bank deleveraging will almost certainly target outstanding speculativegrade loans due to the higher capital reserves required in connection with these higher risk loans. Meanwhile, among speculative-grade borrowers seeking bank loans for refinancing and business development, those with financial sponsors will likely receive greater ongoing bank support due to the depth of their sponsors’ bank relationships.
Ultimately, while the impact of any bank credit rationing will be more acute in Europe due to the greater reliance on bank debt in that region, non-sponsored speculative-grade borrowers will likely be most vulnerable to reduced bank lending.
High Yield Bonds: A Capital Markets Alternative to Bank Debt
Many speculative-grade borrowers have never entered the capital markets due to their familiarity with relationship bank lending and the ability and willingness of banks to satisfy their debt capital requirements. In the event that banks reduce their speculative-grade loan exposure, the high yield capital markets could provide such borrowers an alternative source of debt financing. The latest round of quantitative easing in the US, and similar programs in Europe, should sustain the existing environment of low prevailing interest taxes and thereby maintain the investor demand for higher yielding investors. As a result, there may also be greater investor tolerance for the liquidity risk often associated with offerings smaller than the $250 million to $300 million traditionally recommended by underwriters for inaugural bond offerings. Smaller issuers can also consider the issuance of secured notes or other structural alternatives to compensate for the greater liquidity risk associated with their offerings.
The purpose of this alert is not to outline all of the legal and procedural aspects of a high yield bond offering. Suffice it to say that an issuance of high yield bonds is an offering of securities that requires the preparation of an offering disclosure document (including audited financial statements), legal and financial due diligence, an underwriting agreement, legal opinions and accountant comfort letters in a process that typically takes eight to twelve weeks from kickoff to closing. Instead, it may be most helpful, particularly for financial and other nonlegal managers, to understand the function and negotiation of high yield covenants as they relate to a potential issuer’s operations and strategic business plan. These are points that counsel should convey to their clients very early in the process of any high yield offering.
Maintenance v. Incurrence Covenants
Perhaps the most significant difference between typical high yield and bank facility covenants is that high yield covenants are “incurrence” covenants, while bank facilities contain “maintenance” covenants. Maintenance covenants require compliance with specified terms on prescribed dates in order to measure a borrower’s ongoing health and to provide lenders an early warning of any business deterioration. Incurrence covenants, however, need only be tested and satisfied at the time a borrower undertakes a particular action, such as incurring more debt, paying a dividend or selling assets. As a result, an issuer generally cannot fall out of compliance with incurrence covenants if it takes no affirmative action. This structural difference is in part an outgrowth of the relative ease with which waivers and/or amendments of covenants can be obtained from a bank group, as compared to a broad group of bond investors, in the event of a potential covenant default. Incurrence covenants enable an issuer, through its chosen actions, to maintain control over whether it would need to undertake a covenant waiver or amendment. While it will generally be more difficult to obtain amendments to bond covenants if the need does arise, they are typically more flexible than bank covenants on their terms and also less restrictive to the extent of the issuer’s higher degree of control over covenant testing.
Covenant Limitations and the Issuer’s Business Plan
High yield covenants are contained in indentures most often governed by New York law, regardless of the jurisdiction in which the issuer is located. Indenture covenants are for the benefit of bondholders, though the indenture itself is signed by a trustee. Because the covenants must be included in the offering document that is distributed to potential investors when the bonds are sold, the covenants are established in advance of the offering process through negotiation between the issuer and the underwriters, aided by their respective counsel.
Generally, the objectives of high yield covenants are to:
- Protect the issuer’s cash flow for service of obligations existing at the time the bonds are issued, including the notes themselves
- Prevent the disposition of assets on terms that diminish the value of remaining assets (including consideration received for a disposition) to satisfy the issuer’s remaining obligations, including the bonds themselves
- Preserve the relative priorities of different potential claimants to the issuer’s assets, including limits on payments to holders of lesser ranked debt securities and equity
- Preserve any security provided to holders of the bonds.
High yield covenants typically follow a pattern of general restrictions on various actions, such as the transfer of cash or other assets, incurrence of debt, asset sales, affiliate transactions or incurrence of liens, subject in each case to a number of negotiated exceptions. The negotiation of the covenants is essentially an exercise in balancing the objectives outlined above against the issuer’s need for flexibility to operate its business and execute its strategic plan.
In light of the difficulty in amending bond covenants, it is important when negotiating the covenants that an issuer try to accommodate all of the transactions and business activities that may occur during the typical five to seven year life of the proposed bonds. Among other things, the issuer’s management and financial staff should consider (i) future and existing acquisition plans, investments, joint ventures and divestitures, (ii) current and future financing arrangements, (iii) business expansion, including organic growth and planned new lines of business, (iv) any current or planned transaction or flow of funds and other property between or among the issuer and its affiliates, including those in connection with the bond offering, and (v) the extent to which the issuer expects to satisfy the various ratio and financial calculations contained in the covenants. Through this exercise, and consultation with the issuer’s counsel, appropriate exceptions to all of the restrictive covenants that would otherwise constrain the issuer’s strategic business plan can be negotiated.
Negotiating the Covenants
The underwriters will typically seek to accommodate the issuer’s need for flexibility under the covenants, since execution of the issuer’s strategic plan and growth of its business are presumably in the bondholders’ interest as well. However, the underwriters will also be concerned with (i) the marketability of the bonds (an interest shared to an extent with the issuer), (ii) the covenants’ general consistency with current market conditions, and (iii) the underwriters’ future credibility with their ongoing buy-side relationships. These concerns may be heightened in situations where the offering proceeds will be used to repay a bridge loan or other debt extended to the issuer by the underwriters or their affiliates.
During the course of negotiations, the underwriters will likely resist some proposed covenant modifications on the basis that they are inconsistent with market conditions, or “off market,” to an extent that will compromise the underwriters’ ability to sell the bonds with an interest rate acceptable to the issuer. In these situations, the issuer and its counsel should request that the underwriters articulate both the specific problem with the proposed modification and the estimated “cost” to the issuer in additional basis points on the bonds’ targeted interest rate in order to compensate investors for their perceived additional risk relating to the proposal. Ultimately, it is the issuer that should conduct the proper cost/benefit analysis of the flexibility to be gained from the proposed change and the corresponding cost. The potential issuer may therefore benefit from negotiating the covenants with an experienced underwriter attuned to market demands in order to balance these considerations as accurately as possible. All things considered, the final covenant package will depend on (i) the pricing conditions prevalent in the market at the time of the offering, (ii) the issuer’s required flexibility, (iii) the covenant packages that have previously entered the market for companies in similar industries, of similar size and profitability and of similar credit quality, and (iv) the issuer’s estimate of the term during which it expects the notes to be outstanding (considering the cost of exercising redemption rights in the bonds and the potential for amending and refinancing the bonds, if necessary).
Finally, when negotiating high yield covenants, it is important for the issuer’s financial and other non-legal managers to keep in mind that New York contract law, which governs most indentures, instructs courts to give words and phrases employed in contracts their plain and commonly accepted meanings in light of the contractual obligation as a whole. In other words, issuers should be cautious not to put any weight on intentions that are not plainly expressed in the covenants, even if the intentions are shared by the issuer and the underwriters during negotiation of the covenants. The buyers of the bonds, not the underwriters, are the beneficiaries of the covenants and, if the opportunity arises, they will have the right, and likely the inclination, to enforce the covenants strictly against the issuer in an effort to obtain financial concessions. Experienced counsel can be of enormous aid to the issuer in this regard.
It should be noted that one of the few affirmative covenants almost always contained in a high yield indenture, and one that does require some ongoing maintenance effort on the part of the issuer, relates to financial reporting. US issuers will typically be required to provide to the bond trustee, and post on its website, financial and current reports equivalent to those that would be required if the issuer was a reporting company under the US Securities Exchange Act of 1934. To the extent that the issuer is in fact an SEC reporting company, this obligation will typically be satisfied through its SEC filings. Non-US issuers will generally be subject to ongoing reporting obligations as well. Non-US issuers, however, will typically be subject to the more relaxed requirements applicable to foreign private issuers in the US, the reporting requirements of a foreign jurisdiction, or another standard that will provide bondholders with sufficient information on an ongoing basis.
In conclusion, the expected demand for debt capital in the US and Europe remains significant for the near future, and speculative-grade borrowers are more vulnerable than higher-rated borrowers to any reduction in bank lending that would otherwise help satisfy the demand. Through attention to its business plan and careful negotiation with counsel, potential issuers of high yield bonds can potentially utilize the capital markets to meet their debt capital requirements while retaining the flexibility to execute their business strategies.