European high yield makes a comeback

The European new issue high yield bond market broke previous records in 2004, with the total topping the €20bn mark for the first time in its 12-year history. And a sustained healthy flow of issuance is likely to continue through this year as sponsors examine the possibilities of realising gains facilitated by the fixed income markets.

“Two years ago all high yield was doing was holding company paper with no rights and it was down in the capital structure,” says Bryant Edwards, chairman of the European High Yield Association and a partner at Latham & Watkins in London. Anthony O’Connor reports.

“Now, as a result of pressure put on by the buy side, almost all European high yield has substantial upstream credit support from the operating companies – upstream guarantees- in some cases security over assets,” he says.

“We moved from preferred stock to junior creditors,” says Craig Abouchar, senior fund manager high yield, at Insight Investment, London.

Originally perceived as a US product for US investors, the European high yield market appears to have matured to the stage of becoming a European instrument for European investors. Although still dwarfed by the US, the European total market size between 1993 and 2004 has tipped the €100bn mark.

What’s interesting is that around 75% of all new issues in 2004 were denominated in currencies other than the US dollar, with a trend showing Euro issues strengthening each year.

One of the turning points for the European market came last April when Italian directories business Seat Pagine Gialle brought its LBO to market totalling €1.3bn, which offered an 8% coupon. The media directory publisher broke ground because that deal was denominated completely in Euros.

“Only 12 or 24 months ago there was no way the underwriting banks would have contemplated issuing all of that in Euros,” says Sara Halbard, portfolio manager at Intermediate Capital Manager Partners in London.

“What’s interesting is that Europe no longer needs US investors,” she says. “There are a lot of deals that are getting done now without banks even needing to take a company on a roadshow to the US. Europe is now willing to look at a number of different types of things that a couple of years ago would have been more difficult.”

With the record issuance figures for 2004 has come greater diversification of deals, with high yield being used in lots of different financings. These have included fallen angels refinancing, a healthy amount of LBO-related issuance and increasingly high yield is being used by mainstream corporates.

While the US continued to lead Europe in the aggregate size of sponsor-led buyouts with the US recording over US$60bn in deals last year (Europe lagged behind by around 10%), Europe actually completed about double the amount of deals.

Market estimates suggest there is around US$60bn of untapped funds in European buyout funds and as much as US $90bn in US funds that are dedicated to or available for European acquisitions. Assuming a transaction would feature a 25% equity element, it is estimated by the European High Yield Association that existing funds could support around US $600bn in future leveraged acquisitions.

If private equity sponsors are turned off by the so-called pass-the-parcel or secondary buyouts and if the softness of the IPO market is dampening exits, some sponsors are turning to the high yield market, not necessarily to exit but to realise returns on their original investments.

“Last year, you started to see some equity investors taking money out of existing investments by a doing a non-cash pay, very junior structured subordinated bond,” explains Edwards.

Kabel Deutschland (KDG) has proved to be an impressive example of companies using the high yield market to pay a healthy dividend to its shareholders, resulting in the sponsors recovering 131% of their original investment in the company, while still retaining 100% ownership, less than two years into the investment.

Apax, Providence and Goldman PIA acquired KDG in March 2003 for €663m. In July last year KDG paid a €475m dividend to the sponsors from a €750m high yield issue. In December, KDG paid a further €400m dividend through 10-year floating rate PIK holding company notes.

“The structure of that deal effectively works as a one-year bridge to an IPO,” says Edwards. “People are looking at the leverage on the Kabel Deutschland deal which was roughly five times, and adding another turn of leverage, bringing it up to six times debt to EBITDA.”

“I think we will see more of these deals for some of the better quality credits in the first quarter of this year,” he adds.

“The only limiting factor is that the company has got to be big enough for the PIK issue to be at least €100m in proceeds, because if it drops below that it would be too small and a lot of people would not feel comfortable holding it,” says Halbard. “The interesting thing about the PIK issue is that it is not being sold to the mainstream high yield bond holders – there will be a smaller number of that type of paper.”

Other sponsors also realised substantial gains in 2004, raising the question whether following the IPO route is necessarily the best solution for every company.

BC Partners bought German cable company Tele Colombus in July 2003 for €202m. In April last year BC Partners took €188m off the table in a €475m issuance of floating rate notes and 9.375% fixed rate senior notes.

It used the proceeds to repay shareholder loans, make a distribution to shareholders and to repay additional indebtedness.

Back in 2002, Charterhouse invested £250m in betting company Coral. In February 2004 the sponsor completed a leveraged recapitalisation and paid itself a £220m dividend.

In December, Coral completed another recapitalisation from which it was able to realise £400m. In total, Charterhouse has recovered 248% of its original investment, while still holding 100% of the company.

In November 2004, Apax and Permira took €301m out of Inmarsat through an offering of holdco discount notes. They bought the company in December 2003 for €653m, and so their dividend last year equalled 46% of the original investment. The holdco structure was used to avoid payment restrictions in bonds issued to finance the original acquisition.

German companies played an important role last year in boosting the total size of high yield issuance in Europe, with most of those deals structured as refinancings, with a peppering of LBOs.

“The biggest trend in 2004 has been the increase of German deals with the long-awaited arrival of the mittelstand, issuing senior level term debt and moving up the capital structure better enabling them to preserve and generate cash flows instead of constantly paying back bank debt to reinvest in the business,” says Abouchar.

As well as finding geographical diversity of issuers, the high yield market in Europe appears to have found more comfort with those industries using the product.

“I think it was a little bit unfortunate that when the European high yield market started it started to finance venture capital deals in telecoms,” says Abouchar. “We’re now financing the types of companies that we are supposed to with high yield; that is, more industrial companies.”

European buyouts showed a marked diversification in 2004 with industrials leading the way, followed by retail, consumer products and media, with telecoms and high tech way down the list.

Demand for high yield paper has picked up in recent years as more retail funds focus on the market, coupled with better allocation levels from institutional investors for the asset class. “You see pension fund and insurance company money making a deliberate allocation to high yield, possibly as a more corporate outlook,” says Halbard. It can be said, however, that the cultural hurdles that have faced the high yield market have not really been on the buy side.

“The problem has been on the issuer side where they were loathe to come to the market and be a junk company, as it were, and they perceived it to have negative connotations,” says Abouchar.

“A lot of people have asked why they would issue debt at 8%, 9% or 10% when they can issue equity which is free. I think people are realising that there is a certain amount of cost associated with issuing equity and that a certain amount of term debt in the capital structure is appropriate.”

Macro-economic factors are also boosting the appeal of high yield issuance in Europe. “It’s helped that we’re in a very low interest rate environment and coupled with that spreads have tightened a lot and the level of coupon that they actually pay is at an all-time low, so it’s a great time for them to turn out,” says Halbard.

Demand for European high yield is growing again in certain collateralised debt obligation (CDO) structures and of course from credit hedge funds looking for trades and not just looking for arbitrage trades.

Halbard says: “I think particularly with the influence the hedge funds have had on the market over the last 12 to 18 months, this is one of the driving forces of convergence across all markets because they aren’t limited in their mandate and scope in terms of what they can do. A hedge fund will buy credit risk where they see the most optimum risk reward.”