Structural subordination struggle

The long-running conflict between Europe’s high yield bond and senior debt investors over structural subordination has come to a head. If unresolved, the issue could endanger the financing feasibility of larger LBOs and the growth of the high yield market. Joanna Hickey reports

Continuing improvement in Europe’s high yield bond market will hinge on wider global economic and political events, but there is another serious obstacle looming over Europe’s high yield bond market; the thorny issue of structural subordination.

This battle between Europe’s high yield bond investors and senior debt lenders has raged for years. However, the row has finally come to a head, with the December “buyers strike” – where a group of bond investors threatened to boycott all European LBO deals if their security was not improved. And then in January that was followed by the Legrand and Brake Brothers loan waiver requests to allow subordinated upstream guarantees for bondholders.

Unlike in the US, where high yield bond investors are only contractually subordinated to senior lenders, in Europe high yield bond investors are structurally subordinated and even rank behind trade creditors.

The situation varies across the different European jurisdictions, with companies in certain countries legally unable to provide upstream guarantees to even senior lenders. In such cases, senior debt is often split between debt lent to a holding company (holdco) or a newco, which is secured against share pledges of the operating company (opco), and refinancing debt lent directly to the opco, which can be secured against opco assets. However, as most buyout companies are multi-jurisdictional, they usually have assets in at least one country where upstream guarantees are allowed, so senior lenders at the holdco/newco can still have security on part of the target’s assets.

Bondholders’ position is weakest in the UK, where banks can appoint an administrative receiver in a default situation that effectively works for them. The entity issuing the high yield bonds in the UK is typically an SPV or holdco above the senior debt, which sits at the opco or first holdco level and benefits from upstream opco guarantees. Senior lenders have a charge over shares in the opco, first charge over its assets and cash flows and thus hold all the cards in a default situation. In most cases, most infamously Energis and Polestar, bondholders have been very badly burned in default situations.

Given that the UK is the biggest LBO market in Europe and that UK companies legally can give upstream guarantees to secure debt, bondholders stand to gain a great deal and the debate is therefore at its most heated there.

European mezzanine investors, on the other hand, sit at and lend to the same level as the senior debt and benefit from both second ranking security and upstream, senior subordinated guarantees from the opco, which can be enforced after a three to five-month standstill period. Thus European mezzanine lenders have a seat at the restructuring table and a higher recovery rate.

European bondholders are initially seeking contractual subordination similar to the US model, with senior subordinated upstream guarantees from the operating company in countries that allow this. This would rank them alongside trade creditors and give them a voice in default situations.

However, ultimately Europe’s bond investors want to rank with mezzanine – to sit at the same entity as the senior lenders and be second secured, with a second charge on security and maintenance financial covenants. This second ranking would put them ahead of trade creditors and give them far greater power in workout. Most senior lenders feel that second ranking is a step too far. “This argument is currently focusing on contractual subordination with upstream guarantees – there is no way they will get second ranking,” said one LBO specialist.

Passions are running high among both camps. “This issue has been running for five years, but is coming to a head as the financial markets are hurting and we have more power. With the current surfeit of fallen angel paper, the high yield bond market does not need LBOs at any cost right now. If our security position in buyout deals is not improved, then we will look elsewhere to invest,” says Martin Reeves, director of European and Asia-Pacific Credit Research at Alliance Capital.

;European high yield bonds are at present quasi-equity and this has to change or investors will look elsewhere for better risk-adjusted returns. There is no reason why we should not share security with senior lenders, as long as it’s at a subordinated level,” says AXA Investment Managers’ Stanley.

Senior debt lenders such as CDOs, banks without a high yield operation, and those that just do smaller deals are mostly against upstream guarantees to bondholders. “It’s only 10 guys on a buyers’ strike and a small group of banks at the highest level – the investment banks and those with a high yield capability – that want this. Eighty per cent of the loan market is against this and we hold all the cards,” says one LBO banker.

Many senior debt lenders harbour a distrust of high yield bond investors and their distressed counterparts, the dreaded vulture funds, preferring the predictability of mezzanine investors, which do their own credit work and are deemed by banks to behave more like them in a work-out situation. “There’s a feeling amongst senior lenders that, after the standstill period, bondholders would probably demand repayment. Banks want flexibility to work things out with companies but bondholders are not driven in that way – they might prefer to sell out at 30p in the pound than sit through a restructuring. Senior lenders could end up having to buy out bond investors and this implies that leverage needs to come down to a level at which the banks feel more comfortable,” says Willie Orr, head of loan distribution, Bank of Scotland.

Bondholder guarantees would reduce the recovery rate of senior debt, causing ratings agencies to downgrade it. “The high yield bond market appears to want to maintain senior leverage at the current levels and take away their structural subordination. The two are incompatible for the senior debt market, which has to safeguard its position one way or the other,” says Ian Hazelton, chief executive, Duke Street Capital Debt Management.

Precedents exist

Despite the entrenched views of some sectors of both markets and the furore over Legrand and Brake Brothers, precedents of some sort of high yield bondholder protection or upstream guarantee have been established in the past six months. However, the precedents – Nycomed Pharma, Haarman & Reimer, Trespaphan, Ecobat, Barry Callebaut, Kamps and Teksid – have all been regional deals, with access to local liquidity, very low senior leverage and extremely restricted bondholder security, with the bond issuing vehicle still structurally subordinate to the bank debt vehicle.

For example, in February, Nycomed Pharma’s senior debt sold successfully via CSFB and SEB, but given the jurisdiction, had only limited upstream guarantees on eight

per cent of the company’s EBITDA for the forthcoming bond, extremely low senior leverage of 2.4x and a mostly regional syndication.

;To date, the deals that have had upstream guarantees have been marginal. Also, in reality, a lot of senior lenders were not actually sure what they were giving away. Legrand, being a far bigger deal, concentrated everyone’s minds on the issue and what is at stake. Senior lenders are making such a fuss now because they fear this will become the norm, rather than the exception,” says one LBO banker.

Legrand’s waiver request to allow bondholders subordinated upstream guarantees on 20 per cent of its revenues ultimately failed due to bond timing issues as well as bank resistance. By mid-March, the jury was still out on Brake Brothers. Initially the deal offered an amendment fee of just 12.5bp, but when nearly all the syndicate refused the waiver, the lead banks increased all tranche spreads by 50bp – a move that appeared to mollify the lenders.

Alternative solutions

Should the impasse between the two markets continue, underwriting banks have few financing alternatives at their disposal. One option, as seen with Legrand, is to turn to the US high yield bond market. If paid sufficiently, US investors have proved willing to countenance European structural subordination due to their broad risk diversification and far larger market.

However, recourse to the US market is only really feasible for companies that have US subsidiaries and revenues, given the swap costs that would otherwise be involved, and it is also an expensive option for the sponsor. From an initial price talk of nine per cent, Legrand sponsors KKR and Wendel ended up paying

11 per cent to US and 10.5 per cent to European investors. “The high yield community extracted a very high coupon on Legrand because of structural subordination,” says one bond investor.

The other option is the mezzanine market. Partially in response to the instability of the high yield bond market, the level of mezzanine investment in European buyouts has rocketed in the past seven years. While €150 million mezzanine was the maximum achievable for a single deal just three years ago, €500 million is possible today, following the record €300 million mezzanine tranche for Telediffusion de France last year.

Despite the fact that it is more expensive than bonds and has more onerous covenants, mezzanine is now often preferred to the execution risk of bonds in LBO situations – as seen with Trespaphan and Haarman & Reimer which, despite securing approval for upstream guarantees, looked set to go the mezzanine route by mid-March. “Sponsors prefer the stability of mezzanine, despite its higher cost. Given the potential extra cost that moving a high yield deal to contractual subordination would incur in terms of compensation to senior lenders, lowering senior leverage and increasing the equity or subordinated debt to compensate, mezzanine looks even more attractive,” says Adam Hewson, head of European mezzanine at UBS Warburg.

However, with €500 million the absolute maximum for mezzanine compared to €1 billion to €1.5 billion for high yield bonds across the European and US markets, it can only be used in LBOs under a certain size.

In addition, as the mezzanine market has grown, new investors – including a number of high yield bond investors – have started to invest in the asset class. More worryingly for senior lenders, although mezzanine remains an illiquid instrument, it has changed hands in secondary and in distressed situations, vulture funds have invested. As high yield investors are at pains to point out, this fact reveals a certain irrationality in the argument against contractual subordination and begs the question why banks are happy to give mezzanine second ranking security but not bonds. “Senior lenders must take into account that the mezz and high-yield markets will continue to converge over time,” says Hamish Buckland, head of leveraged finance debt products at JP Morgan.

A problem solved

Given the limited possibilities of the financing alternatives, many think that a resolution to the standoff will be reached, despite the entrenched attitudes nurtured by some market participants. There has been an element of posturing in the noise surrounding the issue so far, which will disappear as more precedents are established. Attempts to import US practices into Europe’s highly conservative loan market have traditionally provoked hostile initial reactions – as seen with innovations such as market flex or the withdrawal of sponsor equity before senior debt through leveraged recaps – but, with time, both were accepted.

In addition, some of the most vociferous protesters in both markets have already caved in at least once. While Legrand was one of the best deals of 2002 and as such is a case apart, the fact remains that a number of the “buyers strike” institutions went on to buy the bond, while some banks that had agreed to the Legrand waiver request ranked among Brake Brothers’ most voluble detractors in February.

Most large LBO banks with strong high yield bond desks are under internal pressure to be more flexible, and so they are working to find a compromise. “It is in the interest of most of the bigger players to give the bondholders more security, as the larger deals need the high yield bond market. And even for smaller deals, it is healthier for the market if there are alternatives to mezzanine,” says Oliver Duff, head of loan syndication at Goldman Sachs.

Compromise is possible, but will involve pricing and structural changes in the European senior debt market. “As an institution, we are not against contractual subordination as a concept – after all, we lend on a broadly similar basis in the US. But the US market has shorter tenors, higher pricing and lower leverage for senior lenders. In my view, unless senior lenders are accommodated on these issues – particularly pricing and leverage – they are unlikely to accede to demands from high yield investors. We also need to bear in mind that the vast majority of European LBOs can be done without high yield,” says Bank of Scotland’s Orr.

For many senior lenders, the main complaint is that so far, they have been asked to give up some seniority on deals initially structured without upstream guarantees, for the same senior leverage and only paltry compensation. Brake Bros’ initially offered an amendment fee of just 12.5bp for upstream guarantees on 80 per cent of assets. “Part of the problem with Brake Brothers and Legrand was that senior lenders had already had to get approval for one structure. If structural subordination is removed or reduced from day one, senior lenders would be more open to it,” says one banker.

Reducing senior leverage is the most vital concession, as the risk of the asset class is being increased. If senior leverage was reduced, most concur that up to 80 per cent of the market would accept upstream guarantees for bondholders, as long as they were also paid enough – although the concept of bondholders also getting second ranking security is still deemed out of the question by nearly all of the senior debt market.

Senior debt pricing increases are likely to vary in line with the jurisdiction – UK upstream guarantees would be more substantial as there are no legal constraints, so senior lenders are likely to demand more compensation. Most lenders concur that a 50bp to 75bp margin hike and fees of 10bp to 15bp would be required. “It is really down to the financial sponsors. If they pay the banks enough compensation, they can resolve this,” says Alliance Capital’s Martin Reeves.

The more optimistic point to Nycomed, Ecobat and Barry Callebaut as encouraging signals and expect to see bigger deals in the coming year with upstream guarantees on a portion of assets. As long as the market moves at least in part towards the US model and offers senior lenders compensation, all but a very few players will fall in line. “A few institutions on both sides have entrenched views, but you don’t need every investor to get a deal done,” says JP Morgan’s Buckland.