EUROPE - Yield of dreams: unquote” explores high yield

High-yield is back in fashion. This is hardly surprising; the prevailing low interest rate environment has led yield-seeking investors to fixed rate corporate debt of lower rated companies. "Add to this the general concern about higher equity valuations following the recent rally and it becomes apparent why investors are allocating their money towards the corporate bond space at the moment," posits Oliver Duff, global head of leveraged and acquisition finance at HSBC.

The surging liquidity in the asset class has enabled several large refinancings of high-yield bonds or existing bank debt in corporates, such as in the case of Dutch broadband company UPC, Heidelberg Cement in Germany or UK group Virgin Media. "Indeed, the majority of deals done this year have been refinancings, and corporates have been using the high-yield market as an alternative to the bank debt," explains Duff.

Significantly, though, a primary buyout financed by an initial bond issuance is yet to emerge in Europe. Even the announcement in November of Liberty Global's €3.5bn Unitymedia buyout from BC Partners and Apollo does not, according to some, tick all the boxes. The transaction was backed by a €2.5bn bond and did not represent a radical change to the company's debt structure, consisting of an exchange of old Unitiymedia bonds for new ones and still relying on existing documentation.

Building bridges
Herein lies the crux. While tapping up the high-yield market to finance new buyouts would seem a simple solution to the lack of available bank finance, the transaction process is more complicated. First of all, using high-yield is restricted to larger deals, in general involving bonds worth more than €200m to satisfy liquidity requirements of investors looking to trade their positions.

However, while the transaction size requirement goes some way to explain the absence of buyouts financed by high-yield bonds this year (the majority of transactions taking place in the small- and mid-cap space), the necessity to bridge the bond until it is successfully issued remains the main obstacle.

Unsurprisingly, few banks are currently willing to underwrite larger debt pieces. "When the loan market was liquid, banks had an alternative in case the bond didn't work, as they could convert it into a traditional LBO structure and syndicate it into the loan market instead," comments Andrew Lynn, director at Hawkpoint. "That alternative is gone at the moment; the risk for banks is simply so big that the underwritten piece remains sitting on their balance sheet."

What is more, in the event that a bank is prepared to underwrite the issuance, private equity houses are presented with extremely unfavourable terms and conditions, as Peter Schwartz, capital markets partner at Weil Gotshal & Manges, notes. "The main concern is that if they do not get the bond off, they are stuck with a bridge on bad financial terms, which they can't refinance or take out as they won't find banks to lend. After all, this is the reason they wanted to do the bond in the first place," he elaborates.

With banks generally underwriting bridges only for high quality credits and with rather high pricing levels, a number of alternative options are being circulated, although with little tangible outcome yet. The general consensus is that the vendor's full support is key to a successful bond issuance for a primary buyout.

"You need to get the seller on board because you require proprietary information for the issuance," notes Schwartz. "For example, the prospectus will detail, among other things, three years' worth of financials that need to be signed off by the seller's accountants." Such a cooperation has already been observed in auction processes, where M&A advisers have supplied bidders with the necessary information to get a bond off - in a way, it is a staple finance approach for selling a bond.

Another option would be using vendor notes to bridge to the bond. For the buyer, this would be an almost ideal scenario, as the issuance of the bond is hedged with a vendor note. However, the outcome for the seller can be less favourable. "The shift of finance risk to the vendor has been a main feature this year. But if you're a private equity vendor and the bond issue fails, how comfortable are you owning a huge piece of debt that is structured in a way that works for the new owner?" poses Lynn.

High-yield to the rescue?
In light of such challenges to applying new high-yield bonds in primary buyouts, it comes as no surprise that existing and new issuers are using the current market liquidity mainly to refinance. Indeed, industry observers regard the high-yield market as a potential saviour in the light of upcoming loan maturities that simply won't be able to be absorbed by the existing bank finance capacity.

What is more, having a bond in the capital structure has certain advantages for a company. "Longer maturities in the high-yield bond market, (typically seven years) and incurrence style covenants make bonds more appealing for corporates and issuers in general," argues Duff.

While securing long-term financing is certainly a plus in the current market, lighter covenants are more of a double-edged sword. On one hand, bonds have incurrence instead of maintenance covenants, which means, for example, that positive cash flow and robust businesses that incur a circumstantial dip in their performance ratio are protected from defaulting due to such technicalities.

On the other hand, the reason for only having incurrence covenants is rooted in the vast amount of bondholders and the inability to alter terms and conditions post issuance. Therefore, if the company does get into difficulties and can't meet its payment obligations, the renegotiation of its capital structure when involving a bond is very complex and difficult to achieve efficiently, which can be detrimental to the business.

And high-yield could also be useful in providing sponsors with profitable exits, which have been sorely lacking from the market in recent years. Some suggest that if private equity houses get their portfolio companies' bond ready, they may be able to mitigate against low valuations and achieve higher exit multiples.

At the centre of any such argument, however, remains the question of whether the revival of the European high-yield market is here to stay. After all, the asset class has had a couple of false starts in the past and many cynics regard it as nothing more than a cyclical phenomenon, albeit a highly welcomed one in today's credit market constraints.

A low interest rate environment will undoubtedly be essential for the high-yield market to remain open, but the successful performance of newly issued bonds is also key. "A single, large default of a new issue name has the potential to significantly disrupt the nascent European high-yield market as it has in the past," notes Duff. "On a positive note, we are encouraged by the uptake of the product by corporates in Europe and note that larger transactions are being underwritten on both sides of the Atlantic as confidence has grown."

Given the prevalent financing constraints and scale of upcoming debt refinancings, one can only hope that this is more than wishful thinking and that the high-yield market remains open for some time.

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